Understanding the Banking Industry: Business Models, Revenue Streams, and Economic Impact
Banking Sector Essentials for Beginners Let’s discuss the banking industry and also learn about all the important technical terms used in the banking sector. If the banking sector collapses, the country’s economy would also collapse. For this reason, around one-third of the weightage in the Nifty index is given to banking stocks. Banking stocks are almost essential to the banking system, and understanding all the important terms related to it becomes easier. Banks are involved in both lending and borrowing.
Banks raise funds through various means, including deposits and loans. They distribute these funds to customers in the form of loans. The interest charged on these loans generates revenue for the bank. In simple terms, this is the business model of banks. They offer different types of loans such as housing loans, business loans, personal loans, and credit advances. Banks also invest in government securities and corporate debt instruments to earn interest. The process of lending money is a fundamental part of their operations.
Also Read : Top Housing Finance Companies in India: best home loan provider in India?
Why Banks Invest in Government Securities: Understanding SLR and CRR Requirements
Since lending money is the core business of banks, why do banks invest in government securities or corporate debt instruments? The reason is that banks are required to keep a certain percentage of their deposits in the form of government securities or other approved investments. This requirement is known as the Statutory Liquidity Ratio (SLR). Currently, the SLR is 18%, which means banks must hold 18% of their deposits in cash, gold, or government securities. The Reserve Bank of India (RBI) revises this ratio based on prevailing economic conditions.
In addition, there is another term called the Cash Reserve Ratio (CRR). According to RBI regulations, banks are required to keep a certain percentage of their total deposits in cash with the RBI. Banks do not earn interest on this amount. Currently, the CRR is 3%. Like the SLR, the CRR is also adjusted by the RBI based on prevailing market conditions. The total income of a bank, known as core interest income, comes from the interest earned on loans distributed and investments in government securities. – Banking Sector Essentials for Beginners
How Banks Generate Revenue and Manage Fund Costs: Fees, Interest Rates, and Borrowing Costs
In addition, banks charge fees for providing various banking services and earn through various commissions, which are categorized as other operating income. Banks also need to raise funds to be able to distribute loans. They obtain these funds through mechanisms such as current accounts, savings accounts, recurring deposits, and fixed deposits. Banks offer different interest rates on these deposits. For example, the interest rates on current accounts and savings accounts vary. Typically, banks offer about 3-4% interest on savings accounts, which is relatively low. This is why banks always strive to manage their interest rates effectively. – Banking Sector Essentials for Beginners
Also Read : Micro Finance Company Ltd 2024: Definition, Benefits, History, and How It Works
Banks try to maintain a high ratio to ensure they can obtain funds at a low rate of interest. In addition, banks have to pay interest on borrowings from the RBI and other financial institutions, which is known as the cost of borrowing. This cost, along with the cost of deposits, makes up the total cost of funds. The RBI sets the interest rates at which banks can lend, known as the repo rate. Sometimes, banks have funds available but lack investment opportunities, so they deposit excess funds with the RBI. The return that banks receive on this deposited amount is called the reverse repo rate.[Banking Sector Essentials for Beginners]
Calculating Net Interest Income and Operating Profit: From Revenue to Net Profit
In terms of net interest income, this refers to the difference between total interest income and total interest expenses. Banks earn interest on the loans they distribute. On the other hand, they also need to pay interest on the funds they have raised, either through deposits or borrowings. To calculate net interest income, you subtract the total interest expenses from the total interest income earned by the bank.
Net interest income is calculated by subtracting total interest expenses from total interest income. To determine operating profit, you deduct operating expenses from net interest income. Operating expenses include employee salaries, building rent, and other costs associated with running the business. From the operating profit, provisions and taxes are then deducted to arrive at the net profit. To understand provisions better, we first need to understand Non-Performing Assets (NPA).
Also Read :
