COMMENT
How Banks Make Money

Have you ever wondered how banks make money?

At their most basic level, banks are just like any other business. But instead of buying and selling widgets they buy and sell money. They make money because the interest they charge on loans is higher than the interest they pay on savings and current accounts. In fact it used to be said that banks operated the "3-6-3" rule. They would pay interest at 3% on deposits, charge 6% on loans and headed off for a round of golf at 3 o'clock!

However, banks have changed considerably in recent years. Whilst it is true that retail banking still plays a big part in group profits, banks no longer rely solely on the interest we pay. In the case of HBOS (LSE: HBOS), for example, retail banking accounts for 39% of group profits, but the rest is made up of fees from Corporate Banking, Insurance & Investments and Treasury activities.

Lloyds TSB (LSE: LLOY) is another bank that has shifted its dependence away from retail banking. The division now accounts for 43% of group profits while other departments that include Insurance and Investments provide the rest. The move away from retail banking has been even more marked at Royal Bank Of Scotland (LSE: RBS). Its retail banking division accounts for just 29% of group profits with Corporate Banking contributing some 37% of total profits.

The upshot of all this is that banks are now considerably more diversified. Consequently, poor performance in any one division, whilst undesirable from an investor's perspective, is unlikely to prove disastrous.

Recently, banks have come under pressure after Barclays (LSE: BARC) warned that bad credit card debts were growing sharply. HSBC (LSE: HSBA) has also seen a marked increase in bad and doubtful debts in Britain in recent months. However, HSBC said bad debts will not prevent it from meeting its earnings targets.

Whilst bad debts are a worry, they are one of the hazards of lending. That said the number of people in financial difficulties is still low compared with the last recession. Nevertheless, credit card companies have been taking pre-emptive action for some time, which should go some way towards addressing the problem. Visa, for instance, said it only issued 3% more credit cards between October and December last year, compared with 17% more debit cards.

In the main, bank profits are expected to grow this year, though growth is unlikely to be uniform across the sector. Amongst the fastest growing are HSBC, RBoS and Barclays, where earnings are forecast to rise about 10%. Currently, they are valued around ten times forward earnings, which does not look expensive. What's more, with yields huddled around 4.5%, banks, in my view, continue to look attractive.

More: Why You Should Invest In Banks | Why Banks Are Cheap

David owns shares in Barclays.