Banks are among the most profitable businesses in the world. According to the data on this Forbes page where they ranked the top 20 members of the Global 2000 list of the world's largest public companies by their profit margins. Unsurprisingly, 10 out of the top 20 are banks and the top 4 companies with the highest profit margins are all banks.
The information from Forbes might seem somewhat dated and I am unable to trace when was the article published. However, a more recent article showing the top 20 companies by profits is also giving similar statistics. Of the 20 companies, 9 are banks. So why are banks so profitable?
Banks these days offer a multitude of financial services. However, their main bread and butter is still interest income from loans. But where do banks get the money to provide those loans? The simple answer is, largely from our deposits.
Most of us save some money in banks because it is not that safe to put too much money at home and putting money at home doesn't yield any interest. As a result of that, the banks are able to amass huge amount of money from savers like us. Of course, banks being banks will not allow the money to just lay there and do nothing. That is why they will loan out those money and earn themselves some interest.
If you have not realized, if you take a personal loan from a bank, the interest is usually much higher than the interest you get from depositing money to the bank. Based on my research, the personal loan with the lowest interest rate I can find in Singapore is from HSBC, at 3.7% per annum.
On the other hand, HSBC is offering up to 1.7% interest on a time deposit. Instantly, you can see that the profit margin is astonishing. It is essentially (3.7% - 1.7%) / 1.7%, which is a staggering 117% profit. But that is not all... Enter fractional reserve!
Fractional reserve banking is a system in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal. This is done to theoretically expand the economy by freeing capital for lending.
The fractional reserve banking system allows bank to hold only a fraction of the deposits that they have in the bank and loan out the rest. In the US, the fractional reserve requirement is 10% of total deposit while in Singapore the Monetary Authority of Singapore mandates a minimum cash balance of 3%.
All these mean that banks can leverage savers' money and make even more profit. Assuming there is a deposit of $1million. The bank can theoretically issue a loan of $10million with it earning an interest of $370k per year. On the other hand, the bank just needs to pay $17k of interest to the depositor. That is 10 times the profitability! Easy peasy lemon squeezy :)
Banks are extremely profitable because they are able to perform an instant arbitrage on the money that are deposited with them. In a certain sense, they are making money out of thin air. No wonder there is a saying,
"Give a man a gun and he can rob a bank, but give a man a bank and he can rob the world"
With all these said, I just want to end by saying that I am actually presenting a very simplistic analysis in this article. Running a bank is extremely complex and much of the costs go to making sure they are compliant with regulations. Moreover, there may not be that much demand for loans such that all banks will be able to earn that level of interest. Therefore, in reality, banks are not that profitable as what I described in this article. But, they are still sure to be profitable enough to dominate the list of top 20 most profitable companies.
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