Banking institutions provide an essential bridge between depositors and borrowers. By accepting deposits and putting those funds into income-earning investments, banks can earn a profit while supporting economic development and growth. How they invest their funds determines their profitability.
Investing Bank Deposits
There are over 6,000 commercial banks, savings and loan associations, and savings banks that accept deposits and invest those funds within the parameters allowed by federal and state agencies. Banking institutions are required to maintain reserves up to 10 percent of their deposits, the exact percentage depending on the type of deposit. The balance can be invested in real estate loans, commercial and consumer loans and government securities, with the banks' profit determined by the spread between what is earned on their investments less what it pays depositors in interest. The mix of these investments varies depending on the state of the economy.
Real Estate Loans
A large part of a bank’s loans are in real estate. Banks create long-term loans on property, including housing, farmland and businesses, line of credit home equity loans and short-term construction loans. Fixed-rate mortgages carry a risk should interest rates rise. In an environment of rising rates, interest on deposits will rise, squeezing the spread between loan and deposit rates. Banks compensate for this risk by issuing variable-rate mortgages or selling their mortgage portfolio to government agencies like the Government National Mortgage Association – Ginnie Mae – which creates securities backed by the mortgages. The bank continues to make money by servicing the loans it has sold.
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Commercial and Consumer Loans
Business loans are an important source of income. Since the businesses are usually depositors as well, banks can readily track their activity and credit-worthiness. Business loans are either fixed amount or line of credit to help short-term financing requirements. Banks also earn significant income from consumer loans, with consumers borrowing for automobiles, furniture, major appliances and a variety of other purposes. One of the most profitable ways for banks to invest their assets is by issuing credit cards. With rates typically well above what the bank pays for its deposits, the spread is large and the profit margin high.
When looking for safety, a bank can invest in government securities – local, state and federal. U.S. government securities offer the highest degree of safety. Treasury bills are short-term instruments that have a maturity of one year or less when they are issued. Treasury notes carry a one- to 10-year maturity when issued, while Treasury bonds have an original maturity date up to 40 years. Because U.S. debt is considered to be exceptionally safe, in times of economic uncertainty banks make fewer loans and put their financial assets into government securities. In the two years following the financial crisis of 2008, for example, bank lending fell by $220 billion, while purchases of U.S. government securities rose by $337 billion.
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