The Secret Banks doesn't want you to know!

What are banks? How does a bank work? What does a bank doesn't want us to know? How does a loan work? Why do banks love fixed deposits? How are interest rates calulated? How do you get eligibile for a loan? What does bank look for when to access your loan request? Why is it easier to get a home loan than an education loan? Why does rich get easy loans and poor doesn't? How to select your bank? How many banks accounts do you really need? Can banks fail?

We will try to understand this in series of blogs. Here, we will understand how a bank works and what they do with the money that we deposit.

The way we perceive banks are totally opposite to what it actually is. We tend to forget that banks are also a "for-profit" business. They are just like any other businesses where their primary goal is to earn profits. We tend to believe that the banks are safe havens where we can park all our money. We tend to believe that these banks earn us more money and are aiding us get richer day by day. But, we are wrong!

Banks need you as much as you need them, if not more.

First, lets understand how does a bank work. There are three ways a bank earns money.

1. Fees. Have you ever got a message of a small amount being deducted as an SMS charge? I get a message every quarter saying Rs. 17 is deducted as SMS charge (that is the only message I get from that account :p). Think of it as transaction fees. Banks charge you when you take out cash from their ATMs. They charge you when you transfer your money through RTGS or IMPS to your father who is sitting at the other end of the country. They charge you for Cheque books, SMSs, minimum balance penalties etc.

2. Interchange fees. Have you encountered few shops who say you have to pay 2% extra if you do a card transaction? That is because the shop keeper is likely to be charged at 2% for using the services of the card. Go to PayPal or Paytm website and check for merchant rates. It can even go up to 4% in some cases. The cards you pay at petrol bunks or at shopping mall, the costs of these are borne by the shopkeeper.

3. Loans. Banks borrow money at much lower interest rates and give out loans at higher rates. It is this source of revenue that we need to understand from a different perspective.

P.S. There are more ways the banks earn, but it is insignificant for us at this point.

Where do banks borrow money from? The largest amount of money the banks borrow is from the retail investors. That is you and me. The money that we keep in the bank in the form of savings or FD. This is then lent to someone else (may be back to us) at higher interest rate. Essentially, we are the ones who are lending our money to the banks for some annual interest. As we speak (2021 – 2022), savings account rates are as low as 2.5% – 3% annually and FD rates are at 5.5% – 6%. Banks lend this very money to potential home buyers or car buyers at much higher interest rates.

We will talk about how good or bad the FD rates are in the later stage. For now, let us just understand this.

Banks invest your money to earn higher interests and partly share the interests with you for lending your money.

All in all, the money that you have deposited in the bank is a liability for the bank or in other words, it is the amount that bank owes you.

The interest rates that the banks offer are unfortunately much lower than the inflation rates. When the prices of everyday items rise at 6-7% every year, your money grows by just 2-3% in bank. Effectively, you are losing money every year. This does not mean you have to take out all your money from the bank and invest it elsewhere. What banks promise us is safety and easy of access to our funds (liquidity). we can not achive the same degree of safetly and liquidity elsewhere. Savings and fixed deposits have their own purpose.

The money that you would need for everyday use, the money that you would need for any emergencies and the money that you need for any short term goals or purposes (buying something in a few months, wedding in a year or two, higher education, childrens school fees etc. ) are to be kept in savings account or fixed deposits. Everything else that has long term goals attached to it has to be invested in a little higher riskier assets (Mutual funds, stocks, gold, real estate, etc.)

Now that you understand how a bank works, let us understand how do we start accumulating wealth.