A bank offers a number of financial services among which, two are primary: It helps people to keep the surplus funds in safe custody and it helps people in need of money to utilise the money for a fee. The utilisation fee is called "interest". A bank acts as an exchange between the "haves" and "have-nots" (usage not in the traditional sense) - As in modern times (with the traditional usage of the terms), it is the "have-nots" who keep the money and the "haves" who utilise that money - okay, leaving that aside.
Banks have to carry out the daily operations, pay the salaries of employees. Over and above, banks have to make profit to sustain in the business. So, they keep pocketing a portion of money that they get as "interest" from the borrowers and pay the remaining as the interest to the depositors. The depositors are of two types: "I want my money any-time when I ask" and another with: "Keep the money for 1 year, 2 year and give me at the end of the period" - The first category of people are the ones who keep savings account and current account with the bank - and because of the additional privilege of having money any time they need, the interest they get is typically lesser than the people who ask the bank to keep the money for a defined duration of time. Savings bank earn around 4% and there is no interest for the current accounts. So, effectively there is a trade-off between higher interest versus liquidity. People would be willing to forgo a portion of their interest for the convenience of taking out money any time. Between a savings bank and current account (the difference of 4% versus 0%), there exists a convenience premium for the current account holders to get money even when there is no balance left in the account (a facility called "over draft")
The Current Accounts / Savings Accounts (CASA) are the "demand liabilities" and the fixed period deposits are the "time liabilities" - Any deposit with a bank is a liability for the bank - it needs to pay back and also there is a continuous cash outgo from bank because of the same.
The borrowers take money from the bank for a fee which is ought to be paid monthly / quarterly or any specific period as agreed with the bank. Here again, the borrowers with whom the bank has enough trust in terms of past history or in terms of quality of the collaterals collected for the loan, get an advantage in terms of lower interest rate. Borrowers with not so great credit background will have to pay more for the same loan, because the bank is taking an extra risk for which it needs to be compensated in the form of an additional interest. When I say "high credit quality", it means the probability with which the loan becomes a non performing asset (regular interest not being paid) is lower.
A bank cannot say to a depositor that 10% of its borrowers defaulted on the loan, so the depositors will get only 90% of the money. Because a bank offers such a protection, there must be a fee (which it gets in the form of interest rate difference between borrowing and lending) So, effectively, the depositors are lending to the borrowers with bank acting as an intermediary and taking the entire risk in the process.
What happens if some loans go bad? If the interest is not being regularly paid, beyond an acceptable limit, say 3 months, banks will treat the loan as non-performing asset (Means, loan is an asset for the bank because it generates the income - and since the interest is not being paid regularly - it is a non-performing asset). Once marked as non-performing asset, banks have to provision for the possible losses from the loan. So, the provision takes a hit on the profit for the year. As bad loans increase, provisions increase. The sustained hits on profit later translate to a hit on the reserves and surplus, and slowly wiping off the equity capital of the bank, in which case the bank fails.
A bank is as good as its asset quality.
Banks have to carry out the daily operations, pay the salaries of employees. Over and above, banks have to make profit to sustain in the business. So, they keep pocketing a portion of money that they get as "interest" from the borrowers and pay the remaining as the interest to the depositors. The depositors are of two types: "I want my money any-time when I ask" and another with: "Keep the money for 1 year, 2 year and give me at the end of the period" - The first category of people are the ones who keep savings account and current account with the bank - and because of the additional privilege of having money any time they need, the interest they get is typically lesser than the people who ask the bank to keep the money for a defined duration of time. Savings bank earn around 4% and there is no interest for the current accounts. So, effectively there is a trade-off between higher interest versus liquidity. People would be willing to forgo a portion of their interest for the convenience of taking out money any time. Between a savings bank and current account (the difference of 4% versus 0%), there exists a convenience premium for the current account holders to get money even when there is no balance left in the account (a facility called "over draft")
The Current Accounts / Savings Accounts (CASA) are the "demand liabilities" and the fixed period deposits are the "time liabilities" - Any deposit with a bank is a liability for the bank - it needs to pay back and also there is a continuous cash outgo from bank because of the same.
The borrowers take money from the bank for a fee which is ought to be paid monthly / quarterly or any specific period as agreed with the bank. Here again, the borrowers with whom the bank has enough trust in terms of past history or in terms of quality of the collaterals collected for the loan, get an advantage in terms of lower interest rate. Borrowers with not so great credit background will have to pay more for the same loan, because the bank is taking an extra risk for which it needs to be compensated in the form of an additional interest. When I say "high credit quality", it means the probability with which the loan becomes a non performing asset (regular interest not being paid) is lower.
A bank cannot say to a depositor that 10% of its borrowers defaulted on the loan, so the depositors will get only 90% of the money. Because a bank offers such a protection, there must be a fee (which it gets in the form of interest rate difference between borrowing and lending) So, effectively, the depositors are lending to the borrowers with bank acting as an intermediary and taking the entire risk in the process.
What happens if some loans go bad? If the interest is not being regularly paid, beyond an acceptable limit, say 3 months, banks will treat the loan as non-performing asset (Means, loan is an asset for the bank because it generates the income - and since the interest is not being paid regularly - it is a non-performing asset). Once marked as non-performing asset, banks have to provision for the possible losses from the loan. So, the provision takes a hit on the profit for the year. As bad loans increase, provisions increase. The sustained hits on profit later translate to a hit on the reserves and surplus, and slowly wiping off the equity capital of the bank, in which case the bank fails.
A bank is as good as its asset quality.
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