The basics of banking

Somebody has questioned how it is that banks can/should make their profits on the spread between deposits and loans.  Sometimes, when we are familiar with a subject we ass u me that everyone understands all the basics.

In the jargon of economics banks are financial intermediaries which means they are the facilitator between people who have money to lend and those who want to borrow.  People with money they don’t want to spend immediately can deposit that money in a bank.  The bankers then lends that money to somebody who has an use for it.

Bankers charges interest on the loan.  Some of that money is paid as interest on the deposit and the balance, the difference between the two interest rates, is the spread with which the banker pays his expenses and takes his profit.  It is very similar to the retailer who purchases goods wholesale and marks them up to sell at a retail price.

DooFi_PiggybankThat is the core business of banking.  Boring.  However there are a couple of additional factors which make banking  very important and very risky.

The first is that banks operate under the fractional reserve principle which means they are required to keep a percentage of deposits as cash or in a form which is immediately available.  This is just in case many people want their deposits returned at the same time.  Loans cannot always be called in quickly.  A “run” on the bank has to be most bankers worst nightmare.  I believe all bankers would lie about the financial health of their banks  to try to prevent a run.

I try to avoid dealing with bank loans staff but a couple of times I have asked how it feels to be creating money.  They cannot believe they are creating money in making loans but to those who have studied economics of money and banking that is what they do.  The process is explained  in the essay “LETS got to market: Dealing with the economic crisis.”  I figure the process is a Ponzi scheme and responsible for a lot of economic evils.  It also gives bankers a great deal of power.  Because banks create money it makes them so essential for the economy they cannot be allowed to fail.

The second complication is that making loans is a risky business in that borrowers are not always able to repay their loan.

This can be a problem for the economy as a whole  because if the banks have to write off  a large quantity of their outstanding loans,  the money supply can drop quickly and without money the exchange of goods and services stops.

Risk also  makes it easy for bankers to take for themselves some huge profits.  The general rule is that the longer the term of a loan or deposit the higher the interest rate charged or paid  because the risk is higher.  Prudent banking requires bankers to match the terms of their loans and deposits so that a loan for five  years is matched with a deposit that is committed for five years.  Thus the depositor gets more interest because he/she is carrying more risk.  In an ideal world the spread will be the same for all time periods.

But bankers can make huge profits by financing long-term loans upon which they receive a high interest rate with short-term deposits upon which they pay low-interest rates.  This way they increase the spread and take the rewards of the  higher risk.  This  tactic increases the risk as interest rates can go up above the returns from the loan or depositors may decide to withdraw their money.  I know of a Canadian financial institution that purchased some government bonds (made a loan) at ten percent.  Management expected interest rates to go down so that the interest received would be greater than what they had to pay on deposits – a nice profit,  This was just before interest rates went up to 19 percent and for a while the loses were considerable for the size of the institution.  Just before the financial crisis of 1907/08  at least some of the Wall Street banks were financing long-term sub-prime mortgages with low-cost overnight deposits.  As it became apparent a housing crisis was in the making the depositors stop renewing their deposits.

Of course when risk becomes reality and banks are faced with huge loses they are so important they cannot be allowed to fail and taxpayers end up paying for the risk.

So there you have it.  Prudent banking is simple and boring.  Breaking the basic rules brings in huge profits and ends with a major crisis.

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4 Responses

  1. Thank you for explaining the spread. The article made things clearer for me. As far as I can understand, the Fed is using short term bonds to pay for long term mortages and which will drive the long term interest rates down and make the bonds more expensive. Could you explain exactly from whom the Fed buys the bonds (loans) and how the bond process works.

    • Hi Mona,

      Thanks for your comments. Your questions are interesting and challenging. It is the Wall Street banks rather than the Fed that are using short term deposits to finance long-term loans.

      I am going on to another project and will not be able to write on this weblog for a while. It will probably be into May before I get back to this.

      If you want you could try and find a basic book on economics of money and banking. Your library probably has one.

      You could also search the web for: central banks, money and banking, the federal reserve, fraction reserve.

      I just finished reading: Too big to fail : the inside story of how Wall Street and Washington fought to save the financial system from crisis, and themselves by Sorkin, Andrew Ross and enjoyed it. Your library probably has it.

      Keep asking questions.

      art

  2. Also how do investors take the money they get from the Fed and invest it in the stock market? I just have a slight problem figuring out exactly how this works. According to the Wall Street journal, commodities are going down? Why? Why is the Stock Market so attractive, and why are Health Insurers doing so well?

  3. Yes, Banks create money through a process called ‘disintermediation’.

    When I explain this process to my students thet say “But banks are a fraud!” I reply “Yes, but a very useful fraud. That is why they are allowed to continue.”

    On the second point – risk premiums. Banks are also in the business of insurance. As I explained in another blog, banks charge an insurance premium for risk.

    There are two current practical issues for this. 1. Unlike insurance companies, banks are not required to retain sufficient reserves to cover the risks they are underwrting. In fact, in recent times, these reserves have got smaller. 2. Empirical research has shown, surprise!, that these risk premiums do not cover the risks. If the banks were insurance companies they would go broke. Which they do.

    Ultimately it is the government which is the ultimate bank insurance companies, and the government should charge a full risk premium/insurance premium on all interest payments.

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