How a bank works and makes money
Customers, products, the bank profit tree, capital and liquidity in plain words, and Islamic banking basics.
Industry brief, with a one-minute summary: Retail and commercial bankingKey takeaways
- A bank borrows money cheaply, mostly from depositors, and lends it at a higher interest rate.
- Onboarding and KYC (know your customer): checking identity and the source of money, to stop fraud and money laundering.
- Credit underwriting: deciding who gets a loan, how much, and at what price, often with a credit score.
- Servicing and collections: sending statements, collecting repayments, and working with customers who fall behind.
Key idea
A bank borrows money cheaply, mostly from depositors, and lends it at a higher interest rate. It also earns fees. Its profit is what is left after the costs of running the bank and after the loans that are never repaid.
Start with the customers. Retail banking serves individuals: salary accounts, savings, cards, home loans (mortgages), car loans, and personal loans. Commercial banking serves businesses, from small shops (often called SMEs, small and medium enterprises) to large companies: business accounts, loans, trade finance (money and guarantees that help a company import or export), and cash management. Many banks also sell wealth products and insurance to their customers.
A deposit is money a customer places with the bank. The bank owes it back, so for the bank a deposit is a debt. A loan is money the bank gives to a customer, who repays the principal (the amount borrowed) plus interest (the price of borrowing). On the bank's balance sheet, deposits are liabilities and loans are assets. This is the opposite of how a normal company looks, and it confuses many candidates.
- Bank profit before tax
- Key: Net interest incomeInterest earned minus interest paid. Roughly average interest-earning assets x net interest margin.
- Loan volume, by product (mortgages, cards, business loans)
- Loan yield: the interest rate charged
- Funding cost: the rate paid on deposits and on the bank's own borrowing
- Fee and commission income
- Cards and payments
- Account and service fees
- Wealth, insurance, and trade finance fees
- Operating costs (minus)
- Staff
- Branches and ATMs
- Technology and data
- Marketing and regulation
- Credit losses (minus)Also called impairments or loan loss provisions.
- Loans x cost of risk (expected losses as a share of loans)
Every bank profitability case uses these four branches. Split each one into volume, rate, and mix.
| Line | Approximate share of total income | What moves it |
|---|---|---|
| Net interest income | About 55 to 75 percent (about 58 percent for EU banks as a whole in mid 2026, EBA) | Loan volume, interest rates, and how fast deposit rates follow market rates |
| Fee and commission income | About 25 to 40 percent | Card spending, payments, wealth sales, trade finance |
| Operating costs | About 40 to 60 percent (this is the cost/income ratio) | Staff, branches, technology |
| Credit losses | Often 5 to 15 percent in normal years, far more in a crisis | The economy, lending standards, collections |
| Profit before tax | What is left, often 25 to 45 percent | All of the above |
So-what
These are rough ranges from public bank reports and vary widely by country and year. Use them only to spot a line that looks out of place.
Capital and liquidity in plain words
Capital is the owners' money in the bank (equity). It is the cushion that absorbs losses before depositors lose anything. Regulators follow the Basel III framework, set by the Basel Committee at the Bank for International Settlements. It asks banks to hold capital equal to a minimum share of their risk-weighted assets: each loan is weighted by how risky it is, so a risky business loan needs more capital than a home loan. The key measure is the CET1 ratio (common equity tier 1, the highest quality capital, divided by risk-weighted assets). The Basel minimum is 4.5 percent, plus buffers on top; large banks usually run well above the minimum.
Liquidity means having enough cash, or assets that can be sold quickly, to pay depositors who want their money back. The liquidity coverage ratio asks a bank to hold enough high-quality liquid assets to survive 30 days of heavy withdrawals. Why this matters in a case: every new loan needs capital. More capital makes the bank safer but lowers its return on equity (ROE: profit after tax divided by equity). So a loan that looks profitable can still be a poor use of capital.
Islamic banking basics
Islamic banks follow Sharia (Islamic law) principles. They do not charge or pay interest (riba), avoid excessive uncertainty (gharar), and do not finance activities such as alcohol or gambling. Each bank has a Sharia supervisory board of scholars who approve its products. Instead of lending money at interest, Islamic banks use contracts based on trade, leasing, or partnership. The Islamic Financial Services Board reports that the global Islamic finance industry held about USD 3.88 trillion of assets at the end of 2024, with the Gulf (GCC) countries holding 53.1 percent. Malaysia, Indonesia, Pakistan, Turkey, and the UK also have Islamic banks.
| Contract | How it works | Typical use |
|---|---|---|
| Murabaha | The bank buys an asset and sells it to the customer at cost plus an agreed profit, paid in instalments | Car finance, goods, trade finance |
| Ijara | The bank owns the asset and rents it to the customer; ownership can pass to the customer at the end | Home finance, equipment |
| Diminishing musharaka | The bank and customer co-own the asset; the customer buys the bank's share bit by bit and pays rent on the rest | Home finance |
| Mudaraba | One party provides money, the other manages it; profit is shared by an agreed ratio, and the money provider bears losses unless the manager was negligent | Investment accounts |
| Sukuk | Certificates that give ownership in assets or projects and pay a share of their income | Bank and government funding |
So-what
The pricing of these contracts is usually set with reference to market rates, so an Islamic bank's profit behaves much like net interest income. Analysts often call it net financing income.
An Islamic bank in the UAE buys a car for AED 90,000 and sells it to a customer under murabaha for AED 108,000, paid in equal monthly instalments over 3 years. What is the monthly instalment in AED?
Operations: what a bank does every day
- Onboarding and KYC (know your customer): checking identity and the source of money, to stop fraud and money laundering.
- Credit underwriting: deciding who gets a loan, how much, and at what price, often with a credit score.
- Servicing and collections: sending statements, collecting repayments, and working with customers who fall behind.
- Payments: moving money through card networks and national payment systems, many of them now instant.
- Treasury: managing liquidity and the risk that interest rates move against the bank.
- Risk and compliance: meeting capital, liquidity, and conduct rules, and reporting to the regulator.
- Channels: branches, ATMs, call centres, relationship managers for businesses, and the mobile app.
| Metric | Plain definition | What good looks like (approximate) |
|---|---|---|
| Net interest margin (NIM) | Net interest income divided by average interest-earning assets | About 1 percent or less in Japan (Bank of Japan), about 1.6 percent on average for EU banks in mid 2026 (EBA), about 3.3 percent in the US (FDIC, mid 2026), and about 2.7 percent at state-owned and 3.9 percent at private banks in India (July to September 2025) |
| Cost/income ratio | Operating costs divided by total income; lower is more efficient | Below about 50 percent is usually seen as efficient |
| Cost of risk | Credit losses in the year divided by average loans | Low for mortgages, much higher for cards and unsecured loans |
| NPL ratio | Non-performing loans (usually 90 days or more overdue) divided by all loans | Lower is better; rising NPLs warn of future losses |
| CET1 ratio | Best-quality capital divided by risk-weighted assets | Well above the regulatory minimum plus buffers |
| Loan-to-deposit ratio | Loans divided by deposits | Near or below 100 percent means loans are mostly funded by deposits |
| CASA ratio (common in India) | Current and savings account deposits as a share of all deposits | Higher means cheaper funding |
| Return on equity (ROE) | Profit after tax divided by shareholders' equity | Above the cost of equity, the return owners expect |
So-what
Ranges differ by country, bank type, and interest rate cycle. Compare a bank with its own history and with close peers, not with a global average.
Which source of funding is usually cheapest for a bank?
Sources for this lesson (7)
- Bank for International Settlements: Basel III framework overview (official)
- Islamic Financial Services Board: Islamic Financial Services Industry Stability Report 2025 (official)
- European Banking Authority: Risk Dashboard, data as of Q2 2026 (official, September 2026)
- FDIC: press release on the second quarter 2026 Quarterly Banking Profile, net interest margin 3.32 percent (official, August 2026)
- Bank of Japan: Financial Results of Japan's Banks for Fiscal 2025, chart of interest rate spreads on loans (official, September 2026)
- Business Standard: NIM stabilisation, asset quality and disciplined growth key for banks in 2026 (January 2026, bank margins for July to September 2025)
- Recognized public explanations of case-interview concepts and terms
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