Question

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1. How do commercial banks generate profit?

2. Explain why a dollar today is worth more than a dollar tomorrow.

Answer 1

How do commercial banks generate profit?

in order for any bank to survive without relying on liquidity measures like state intervention to salvage it, it must make profit from several sources. Commercial banks make their money from diverse schemes like investment, credit interest rates and the use of their own banking fees and for cards that they charge their customers.

By making a pool of the large capital base made up of cash deposits, a bank can be able to invest the money in the meantime in profitable schemes that have a financial implication in the bank and through advertising. Another most common standard of doing business by commercial banks is by charging interests on loans that can bring a large amount of profit ranging from a tenth of the amount lent to double the amount or more in certain long-term transactions. In special cases like loans that have a high risk value, especially those extended on an economically insecure basis, banks charge a high interest rate that will buffer the credit consequences in case of loss. In this manner a bank can make a high profit when external factors remain the same and the customer makes good his repayment.

Financial fees like those involved in opening of an account are some of the other means of making money for a bank. This is possible in a case where the commercial bank enjoys a large following which when other long term security measures are excluded has little effect on the custodial expenses that come with the deposit. Other charges include those contained in transfer fees and ATM fees for the city residents who have no access to the physical bank or are constrained by time to visit the real bank. Banks can also offer services of money transfer through cell phones by including service charges higher than normal rates in the telecommunication industry.

Explain why a dollar today is worth more than a dollar tomorrow

The time value of money (TVM) assumes a dollar in the present is worth more than a dollar in the future because of variables such as inflation and interest rates. 1Inflation is the general increase in prices, which means that the value of money depreciates over time as a result of that change in the general level of prices. A dollar in the future will not be able to buy the same value of goods as it does today.

Changes in the price level are reflected in the interest rate.3 The interest rate is charged by financial institutions on loans (e.g., a mortgage or a car loan) to individuals or businesses and TVM is taken into account in setting the rate. Also, the interest rate is what individuals earn on their money by investing it, rather than letting it sit idle in cash, hence another reason why a dollar today will be worth more than a dollar in the future

A basic principle all business majors are acquainted with is the time value of money (TVM). This economic principle states that a dollar received today is worth more than one received tomorrow.

But why is that the case? Money is money and its value should presumably be preserved. The truth is, it isn't though, and intuition behind it is quite simple. Let’s suppose you were offered $500,000 today or $500,000 one hundred years later; which would you choose?
Clearly, the first option is better and it is so for the following three reasons:

1. Higher purchasing powers. Our buying power represents the actual value of our money measured in the services or commodities we can acquire. It is directly linked to the inflation rate and it is no secret that the trend is uprising. So, what does this mean? To simplify matters, just think about how much $100 dollars would get you in 1914 vs. how much it can get you today. Seeing that inflation rate has increased, people’s purchasing power has decreased and $100 today is worth less than it had been in 1914. So depending on the percentage increase in inflation rate and historical trends, we can safely assume that $500,000 today would certainly amount to much more in 100 years.

2. Opportunity cost. With money, opportunity cost mainly refers to your ability to invest the money instead of simply spending it as is. Getting those $500,000 dollars today means you can invest and acquire interest to later on provide you with the principal amount of money, i.e. $500,000 and the additional interest accrued.

3. No risk. Getting the money today ensures you already have it, so there is no worry as to when the money is received, because it already is.

As such, we can say that the sooner we get our money the better and the higher the interest rate, and the more money we’ll have later on. That being said, make sure you keep the time value of money in the back of your mind the next time you’re handling money issues, you just might be in for some big cash.