Back again with another post explaining the basics of banking and trying to explain how essential banking services work so that people can understand them better. For my fellow bankers and others in finance, I promise these posts will get more complex in the future. The goal is to lay the groundwork so that non-bankers can understand me when I e.g. write about capital requirements or how risk is calculated.
As the title suggests, let’s start with deposits. What does it mean when a person goes to a bank, opens an account and deposits money? I’m skipping the process of ‘opening an account’ and that’s for another blog post, because in itself is too complex to explain in a few sentences. Essentially, banks establish relationships with clients and provide their services based on a contractual relationship with their clients. Most of that relationship is regulated and specified in their General Terms and Conditions (which no one reads except the sad people that are tasked with writing them – me being one of them).
According to that contractual relationship and the respective jurisdiction in which the bank operates, when a client deposits money in their account (i.e. gives the Bank their money), it’s not like the bank takes the money down to their safe, to place it in an envelope with your name on it. As I wrote in my previous post, that banks essentially have two books, in this case it just registers the deposit on its ‘who it owes money to’ book as a debt. In financial terms, that is a liability; the bank is obligated to give you that money back if and when you ask for it. So, to state the obvious, when you deposit money, the bank owes you that money. Furthermore, due to competition, banks offer this service for free (or charge very little)! Imagine a you, giving some money to a friend, and saying: keep this safe for me, and be ready to give it back whenever I ask for it (24/7 almost anywhere in the world). Then, imagine your friend’s face when you call him/her on the phone at 2AM and tell him: “Yo, I’m in Costa Rica, and I need 7 EUR of that 500 EUR you owe me, to buy a hamburger. Could you quickly hop on a flight and bring it over? Thanks.”
Why on earth would a company agree to do this and provide this service!? Even more so, do this for free?!!! Outrageous.
En contraire, mon ami! This is where loans come in. What does it mean when you ask for, and the bank gives you a loan? Obviously, it’s the opposite of a deposit: it is a debt that you owe the bank. The bank registers the loan amount in its books as asset, based on the loan agreement, because it has the right to demand that you give back the money that it gave to you. Usually, when banks give you a loan, the loan agreement states that you must pay back the loan amount, plus the interest, which is the cost that the bank calculates for the time that is spent from the date that you have the money, until the date you pay back the full amount. These ‘interest’ amounts are traditionally how banks generate revenue and profit. So, when you take out a loan, the bank expects two kinds of money to be paid back: the principal loan amount, and the interest. Banks go to great length (for financial reporting reasons) to categorise and keep track of those two kinds of money on their books, since one is just boring client deposited money that used to be sitting there doing nothing, while the other is the exciting money that can be considered revenue! Banks use that revenue to pay operational expenses (i.e. rent, utilities, salaries), as well as generate profit (i.e. the dividend for the bank shareholders – the ones that provided the capital to open the bank in the first place).
So, when you deposit that 500 EUR in your bank account, the bank has the possibility to give that 500 EUR as a loan to one of its clients. What if two days after you deposit that money and the bank loans it out, you ask to withdraw for some of it? Where is the bank going to get the money? Well, if the Bank doesn’t have the money to give it back to you, then it will tell you “I’m sorry, come back in a few days”. Then if a few days later, you go back and ask for the money, and the bank still doesn’t have it? Then you will sue the bank, and it will declare bankruptcy, right? Not really. While there is some truth and logic to that, that is a very rudimentary way of looking at this whole process. It may have been the case many decades or centuries ago, and many, many banks have gone bankrupt, but laws and regulations have put very strict requirements on the amounts that banks can loan to their clients in terms of the percentage of the client deposits they have and their own money as well. So, the correct way to look at it is: banks have 5m EUR of deposits from clients and 5m EUR of capital, so they can loan out some of it (i.e. much less than 10m EUR) to their clients. In addition to that, the time element must be included in this process, and this activity must be viewed as a continuous process, where clients deposit money and take loans every day.
How do banks keep track of how much client money they have, the amount of loans they have, and how much of their own money they have on their books? That’s a very complicated process worthy of a few blog posts, but rest assured that they do, because they are legally obligated to do so, and they have to continuously report to the regulator that they are doing it.
So, that’s the shortest and simplest way to explain the traditional business of banking, and how banks make most of their money. It is important to note that banking is a social activity, and it is very dependent on the predictability of human beings. Since people are mostly predictable, banks and regulators can very reliably predict on how much money they have (capital and deposits) can be loaned to their clients. Unless there is a shock event (i.e. a catastrophic environmental event, or a bank run, or coordinated internal and external fraud) you can rest assured that your deposited money is safe with your bank. How safe? That’s a topic for another day. In the next post, I’m going to write about payments, and how they happen almost instantly all across the world.
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