Behind-the-Scenes: How Banks Generate Billions in Revenue

As they say, the closer you are to money, the more money you make. Banks are at the heart of it all and they make a heck of a lot of money. Banks serve as the fundamental building block of the global economy and the modern financial system. They take in and store deposits, facilitate transfers in and out, lend out money to growing startups and small businesses and track changes to balances in real-time. They’re also involved in mergers and acquisitions, derivatives trading, and overnight REPOs with the Federal Reserve—needless to say, they always have their hands in, on, and around money. In this article, we break down the specifics around how Fintech Neobanks make money, let’s dive in!

How do traditional banks make money?

Before we can dive into how Neobanks make money, let’s take a look at traditional banks. Tradition banks (and Neobanks with banking charters) make money primarily through two avenues: deposits and credit. In the former, banks generate revenue through float: the difference between the rate they receive from the Federal Reserve and the yield they pay out to their customers. In the latter, banks generate revenue by issuing loans and charging interest. Essentially, banks make money by leveraging the funds that their customers store with them.

What kind of loans do traditional banks provide?

Most traditional banks offer a host of both consumer and business loan products. On the consumer side, they’ll have automotive loans, mortgage loans, student loans, personal loans, and credit cards, while on the business side, they’ll offer lines of credit, small business loans, short-term loans, startup loans, microloans, and more. Banks that specialize in business banking, typically also offer venture debt, bridge financing, and mezzanine financing.

Where do traditional banks and Neobanks get the money to lend?

Traditional banks can tap into a variety of sources to fulfill lending requests. They can tap into the deposits stored with them by their depositors, they can establish lines of credit with other banks, wealthy individuals, and investors, and they can access capital through the Federal Reserve, through quantitative easing (effectively a loan through the Federal Reserve).

Fintech Neobanks without a banking charter, cannot legally touch or lend out their customer’s deposits. Thus, they need to set up large multi-tranche credit facilities with other financial institutions and banks in order to lend out to others. This creates a few problems for Fintech Neobanks:

• Their cost of capital is indefinitely higher than traditional banks which can tap into low-cost deposits
• Their cost of capital is variable, going up and down with each rate hike or drop by the federal reserve, unlike traditional banks who can tap into stable deposits
• They need to continuously raise credit facilities to satisfy loan demands, unlike traditional banks which can create money out of thin air

The traditional bank loan advantage: creating money out of thin air

Traditional banks (with a banking charter) are required to maintain a minimum reserve of their deposits that they cannot lend out, known as a reserve ratio, today that number is 10%. The other 90% they can choose to lend out however they’d like (so long as they maintain compliance with regulations). Due to the float, banks can create indefinite money (and subsequent loans) by leveraging a single deposit. Let’s see how this works in practice.

Let’s say bank ABC, receives a deposit of $500,000 from person A and is subject to a 10% reserve ratio. This means the bank must maintain $50k on hand but can lend out the other $450k. The $450k is loaned out to person B, who buys a boat. The money is deposited into bank DEF, which again has a 10% reserve ratio. This bank must maintain $45k on hand and can lend out the additional $405k. The $405k is once again lent out, and bank GHI must keep $40.5k on hand and can lend out $360.45k. This process continues on and on and on, creating an indefinite supply of “new” money for traditional banks to lend.

The other half of the revenue equation for banks and Neobanks: float on deposits

In addition to lending out deposits, banks generate revenue through the float: e.g. the difference between the rate they receive from the Federal Reserve and the APY they pay out to their depositors. This float varies from bank to bank and generally speaking, is much larger at traditional banks which receive 4.50%+ APY from the Federal Reserve, but only pay out 0.01-0.04% to their depositors. Neobanks on the other hand, typically have a much smaller float (they receive the same amount, but pay out 100x that of traditional banks at 4.00%+).

In addition to the float, some Fintechs and Neobanks offer Treasury services (which offer an even higher APY). In this scenario, the Fintechs generate yield by partnering with brokerage firms or asset managers and sweeping their deposits into a money market fund managed by a third party. These accounts hold securities, typically ETFs, which subsequently hold Treasury Bills and Government Bonds with varying maturity dates.

Upon maturity, these t-bills and bonds pay out a coupon, which is effectively just interest, which is passed back to those who hold shares of the fund. The benefit is that these investments are backed by the US government, which has never defaulted on its debt payments, making them a safe, virtually guaranteed investment. For a more in-depth comparison of float vs sweeps, check out the blog post we wrote on yield built for this moment.

Other revenue streams for banks

While banks primarily generate revenue through the float on their deposits and through loans, they can also make money in a variety of other ways.

• Banking service & product fees: traditional banks charge for just about everything they can: account maintenance, debit card fees, and ATM fees to name a few. Neobanks on the other hand take the exact opposite approach, they charge for almost nothing. For a more in-depth look, check out the guide we put together on common bank fees.
• Interchange revenues: like credit card companies, banks make money from the fees they charge for processing credit and debit card transactions. They also make money from the interest accrued on credit card balances. 
• Other features and services: Banks typically offer a host of standard features and services to their customers. If depositors want to access additional features, such as bill pay or accounting integrations they are forced to pay fees. Neobanks on the other hand, typically don’t charge for any of the features or services they offer. For a more in-depth look at these, check out the guide we put together on banking features.
• Investment banking and trading activities: Investment banks make money by helping companies raise capital (through an IPO or introductions to private equity firms) and guiding them through a merger or acquisition. Banks also make money by trading stocks, bonds, and other financial instruments, and providing advice to investors.

Final thoughts on how banks make money

As discussed, banks make money by leveraging other people's money. This can be in the form of lending and float, to more complex activities such as investment banking and securities trading. Banks also make money from the fees they charge startups for using their services and products, through transactions that involve their credit and debit cards, and through their one-off features and services. Fintechs and Neobanks without a banking charter, aren’t allowed to touch their deposits, so they make money primarily through the float and management fees. To attract deposits, they pass back nearly all of their unit economics, meaning they pay out a higher APY, and they are typically fee-free. If you’re in the market for a fee-free deposit account that’s built for your best interests and pays 4.00%+ APY, check out Arc.