How Do Banks Work: Complete Beginner’s Guide
Banks and banking, have been a large topic of discussion in recent years. There are some things that are very wrong with banking, but they aren’t what most people normally think about.
Many people blame banks for being reckless, and there are people who associate this with capitalist greed or such nonsense.
In reality, banks are a necessary element in the economy. There is no real reason why people, or the economy, should be subject to how that particular element is behaving.
However, recent changes in the way banks work, have created a system where the activity of banks can affect us directly, and this had a lot to do with the proliferation of the financial crisis.
The Origin of Banking
The first banks originated from associations of merchants who would make loans to farmers and other merchants, normally against their crops and other merchandise. This was an important development for the economy. Because of this, farmers could sustain themselves while waiting for harvest season. Likewise, merchants and traders could fund voyages across the ocean to sell their goods elsewhere.
Merchant banking progressed from financing trade on one’s own behalf to settling trades for others and then to holding deposits for settlement of “billette” or notes written by the people who were still brokering the actual grain. And so the merchant’s “benches” (bank is derived from the Italian for bench, banca, as in a counter) in the great grain markets became centres for holding money against a bill (billette, a note, a letter of formal exchange, later a bill of exchange and later still a cheque).
These deposited funds were intended to be held for the settlement of grain trades, but often were used for the bench’s own trades in the meantime
How do Banks Work
Over the next 1000 years, this practice would evolve into the global financial system we know and (don’t) love today. As banking became more prominent, it expanded its field of business. Insurance companies can also be seen as a form of banking. Banks soon became not only a place to get a loan but also a place for people to store their money. Eventually, banks would also settle transactions amongst their clients. Bank cheques came to be used as a form of money, though they really aren’t.
As the financial system has grown bigger it has become increasingly difficult for the common man to understand how this complex machinery works exactly. Especially when you hear people talking about derivatives, futures, and interest-rate swaps.
One can easily reach the conclusion that bankers are just somehow “taking advantage of the system”, by essentially gambling on the economy and making us pay the price. The truth, however, is a little bit more complex than that.
A regular bank should work like any other business. If we look at a bank’s balance sheet and break it down we can see there’s nothing too strange going on.
Like any company, a bank has assets and liabilities. The bank’s assets are the loans it has made, which it expects to get a return from. The liabilities are money that it owes, either to other banks or depositors. It’s important to understand that when you deposit money in a bank, you are essentially making a loan to the bank.
The bank receives income from its assets and makes interest payments to depositors and other people who have borrowed money from the bank. The difference between these is the profit.
I’d now like to invite you to have a look at the table below.
This image was taken from Wells Fargo’s annual report for 2006. This is page 42 which is a summary of the interest payments received and given for the whole exercise.
As we can see, Wells Fargo gets an average of 7.79% from its loans (that’s your mortgage, credit cards, business loans, etc.) and pays out an average of 2.96% on its borrowings (that’s your savings accounts, current accounts, CDs etc.), producing a Net Interest Margin of 4.83%
This profit shows up in the income statement, the second most important item in the report.
Here we see the interest received ($32 billion) minus the interest paid ($12 billion) producing net interest income of $20 billion. Then there is a provision for credit losses. Afterward, Wells Fargo declares $17.7 billion of net interest income. Then, there is about $16 billion of noninterest income (mostly fees and charges, and don’t we all know about those), followed by noninterest expenses of $20.7 billion, mostly salaries and other compensation. At the end of the day, Wells Fargo made $12.7 billion before taxes and $8.5 billion after taxes.
Quite a lot of work to make $8.5 billion, no? They had to carry a ginormous $481 billion dollars of assets to make that relatively puny $8.5 billion in profit. That’s a ratio of 1.77% (return on assets). Which is sort of low, you could say.
However, the shareholders did pretty well. The total amount of capital invested in the company (crudely speaking) was $45.9 billion, the shareholders’ equity or book value. So, if you had a $45.9 billion investment and got paid $8.5 billion in profit for just one year, that’s a Return on Equity of 18.5%. Sort of like a bond that pays 18.5%. Juicy! That’s why there are so many banks out there.
You can look at it this way: You start with $46 billion dollars. You borrow $436 billion dollars and lend $481 billion dollars (approximately). You make a profit of $8.5 billion dollars.
The difference between the rather mediocre yield on loans (7.79%) low return on assets (1.77%) and the splendid return on equity (18.5%) is due to leverage.
The bank is leveraged at about 10:1, This means for every dollar the shareholders have invested, the bank carries 10 of in assets. This is akin to the homeowner with a 10% downpayment, who carries $500,000 of assets (the house) on a $50,000 down payment and a $450,000 mortgage.
Some of you may be wondering at this point how exactly banks can lend out all their money, while always having cash available for their depositors. This is a very good question and the answer lies at the heart of banking.
To better understand this topic, let’s first define two terms which can sometimes be confused.
A bank, or business, is liquid if it has enough available cash to meet its short-term payments. On the other hand. Solvency is the ability of a company to meet its long-term financial obligations. Banks have to keep enough money in their reserves to be liquid, so that they can make payments on their short-term debts, or simply to allow people to access their deposits. Calculating and changing the bank’s liquidity is somewhat simple. It’s a matter of changing the form of their assets.
If a bank is short on cash all it has to do is call in some of its short term-debts or it can even borrow the money from another bank. In general, however, banks want to loan out all their money, since this is how they profit. This careful act of balancing liquidity is one of the most important things a banker has to do.
Solvency is a little bit harder to measure. It comes down to the quality of the loans the bank has made. At this point rating agencies become involved, but of course, we know they can’t always be trusted. In general, something like a government bond would be considered a secure investment. But things like mortgages or credit card debt have a higher probability of default.
A bank may be illiquid but still be solvent. Liquidity used to be a big problem when banks first appeared. A crisis in confidence may push depositors to withdraw their funds from a bank. Before the age of instant transfers and central banks, this could have meant the end of a bank.
Central banks such as the Federal Reserve and Bank of England were in fact first created with this purpose in mind. The central bank would be a “lender of last resort”. Granting banks emergency funding if they so required. This can work if the problem is of liquidity.
However, there isn’t in reality much a central bank can do if the banks are insolvent. In 2008, the crash in the housing market meant a default on many loans. This did, in fact, make some banks insolvent. They had simply lost too much money to bad investments, therefore making it physically impossible for them to repay their debts.
Commercial vs Investment banking
Since banks are loaning out money, it stands to reason that there should be more and less risky banks. These banks should make different investments, both in risk and in time-frame. This was the case for a long time.
Commercial banks used to be clearly separated from investment banks.
A commercial bank is where you’d have your basic CDs and savings accounts. It’s a regular folks bank. The idea is that, more than anything, they are managing liquidity. With a CD, you are giving the money to the bank under the pretense that you can withdraw it at any time. Therefore, the investments of a commercial bank should be low-risk and easy to liquidate, government bonds, or even monetary funds.
An investment bank, on the other hand, would hold your funds for longer and make riskier investments. It would buy stocks, corporate bonds, and might use some of the more modern financial instruments such as derivatives to bet in the forex market.
Intuitively, this separation makes sense. In 1933 a piece of legislation was introduced in the U.S. known as the Glass-Steagall act which officially separated these two forms of banking. As recently as 1999 this legislation was repealed.
This remains a serious point of discussion in the U.K.
As far as I’m concerned, banking in itself is a necessary institution. I don’t think it is immoral or should be viewed with any more contempt than other businesses.
However, modern banking has a lot of problems which have been discussed a lot, especially since the 2008 meltdown.
For starters, we have the problem of moral hazard, meaning that, due to the protection and privileges that States have granted banks, this has incentivized them to act more recklessly. Thanks to government bailouts banks can privatize their profits while socializing their losses.
Secondly, we have a problem with central banks around the world, using their power to help bankers increase their profits. By systematically lowering interest rates and offering cheap credit, central banks are just making it easier for the financial sector to acquire funds. There used to be a time when banks would have to actually offer their clients a return on their money, and checking accounts would offer returns of 5%. But it has been a long time since those days, and the consequences can be felt.
Finally, there is a problem with the increasing amount of derivatives. The derivatives markets triple every year, and its growth outpaces that of any other market, having reached recently a total estimated value of 100 trillion dollars. Speculation has a place in banking, but gambling does not, and it’s important to understand the difference
Speculation is trying to predict future outcomes, based on forces of nature which may or may not push things one way or another. This means that we try to guess and insure ourselves against the risks created by nature.
Gambling, on the other hand, means betting on risks created by man. When you go to a casino and you spin a wheel and try to guess on which number the ball will land, that is gambling. It is a game of chance and the uncertainty in it is a human creation.
In those two simple definitions, we can find the hidden truth behind derivatives markets. We can understand why derivatives have grown to over 100 trillion, having been virtually nonexistent before the 1930s.
The way in which monetary policy has evolved in the last century has given place to what we have today. Through this dogma of “money supply” manipulation, we have created, us humans, a world of uncertainty in terms of interest rates, exchange rates, and the gold price.
Back in the age of the gold standard, interest rates were stable, and also, notably low and exchange rates were fixed.
Now banks stand to make millions on small changes between currencies, especially due to incredible amounts of leverage. This, I believe, is not a natural or necessary part of banking.
I hope this article has helped shed some light on the issue at hand.