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How banks make profit
The cost of borrowing money is the interest (or dividend) that a depositor or an investor expects to receive. Financial intermediaries (banks) make their profit by obtaining funds from lenders at one rate of interest and re-lending to borrowers at a higher rate.
The difference represents gross profit, out of which the financial intermediary must pay for its own operating expenses and make a net profit.
Now, it might be logical to suppose that if a financial intermediary makes a profit on borrowing and lending, then it would be cheaper for a borrower to try to raise money direct from the lender. In other words, if A has £10,000 to lend, and requires interest on this of 10 % per annum, a financial intermediary might be prepared to pay A 10 % interest to deposit his money and then re-lend it to B at 12 % interest. B would have to pay 12 % to the financial intermediary, instead of only 10 % that he would have had to pay A by obtaining the loan direct. However, financial intermediation probably reduces the cost of borrowing.
A lender will probably accept a much lower rate of interest from a financial intermediary in return for:
(a) the risk-free nature of the investment;
(b) the liquidity of his deposits; and
(c) the convenience.
Current account holders with banks, for example, were traditionally prepared to deposit money for no interest at all, in exchange for its safe-keeping (free from risk of loss), the liquidity of the deposits and the convenience of arranging payments into and out of their account (e.g. by cheque, standing order, cash dispenser etc). Even now, interest-bearing current accounts pay a much lower rate than savings accounts.
Banks are able to earn a reasonable profit by re-lending current account deposits to borrowers at a sufficiently attractive rate of interest.
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