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4Q/2004, Economic Perspectives
How do banks make money? The fallacies of fee income
Robert DeYoung and Tara Rice
Robert DeYoung is a senior economist and economic advisor
and Tara Rice is an economist in the Economic Research
Department of the Federal Reserve Bank of Chicago. The
authors thank Carrie Jankowski and Ian Dew-Becker for
excellent research assistance and Bob Chakravorti, Cindy
Bordelon, and Craig Furfine for helpful comments.
Introduction and summary
“How do banks make money?” is a deceivingly sim-
ple question. Banks make money by charging interest
on loans, of course. In fact, there used to be a standard,
tongue-in-cheek answer to this question: According
to the “3-6-3 rule,” bankers paid a 3 percent rate of
interest on deposits, charged a 6 percent rate of interest
on loans, and then headed to the golf course at 3 o’clock.
Like most good jokes, the 3-6-3 rule mixes a
grain of truth with a highly simplified view of reality.
To be sure, the interest margin banks earn by interme-
diating between depositors and borrowers continues
to be the primary source of profits for most banking
companies. But banks also earn substantial amounts
of noninterest income by charging their customers fees
in exchange for a variety of financial services. Many
of these financial services are traditional banking ser-
vices: transaction services like checking and cash
management; safe-keeping services like insured de-
posit accounts and safety deposit boxes; investment
services like trust accounts and long-run certificates
of deposit (CDs); and insurance services like annuity
contracts. In other traditional areas of banking—such
as consumer lending and retail payments—the wide-
spread application of new financial processes and
pricing methods is generating increased amounts of
fee income for many banks. And in recent years,
banking companies have taken advantage of deregu-
lation to generate substantial amounts of noninterest
income from nontraditional activities like investment
banking, securities brokerage, insurance ag