What is a Bank? What does it do? How does it earn money?
Ray Dalio, hedge fund manager, Bridgewater Associates always breaks complex mechanisms or processes into sum of the parts (Fun Fact – He used this very approach when McDonald’s wanted to launch McNuggets).
Ray Dalio, hedge fund manager, Bridgewater Associates always breaks complex mechanisms or processes into sum of the parts (Fun Fact – He used this very approach when McDonald’s wanted to launch McNuggets).
We will do the same to find what a Bank takes in (input) and what it gives out (output). This will help us understand how a bank functions in a very simple manner!
Bank’s input is the deposits they take from savers. (Cost of funds represents the rate of interest they give to their deposit holders which are savings accounts, term deposits, and other deposits.) Bank’s output is the loans they give to borrowers. 
Bank's input also includes borrowings from other banks and from bonds. So combining all of these source of borrowings from various sources, the combined cost of funds denote the weighted average cost paid. (Cost of funds)
The difference between the loan rate and the cost of funds net of all the other expenses is what they earn in simple words.
Example: For FY19 - A Bank has deposits, Bonds and other bank borrowings as well. Its cost of funds is 6%. Its weighted average loan rate is 9%. For this year fixed and other costs represented 0.5% of loan book. So it earned 9-6-0.5 = 2.5% on its loans!
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