Banks are in the forefront of the evening news and the center of the bailout package. Why are these institutions receiving so much attention? How do they operate? Why are they important?
This issue, we get back to basics and explore how banks work, how their balance sheets are structured, how their earnings are generated and their risks are analyzed.
Since money began to replace the barter system (scholars say in the third millennium BC, but some of us are still trading milk for eggs) banks have played the important economic role of allocating funds to profitable activities. Here is how a simple bank works:
Mr. A has more money than he needs (yes, when we meet him we’ll let you know). He is willing to lend money if he can earn interest on it.
Ms. B has a business idea that requires a major investment. Needing more money than she currently has, she wants to borrow some money and she is prepared to pay interest on the loan. This is where a bank comes in and acts as a broker, using the deposits of Mr. A to lend to Ms. B in a process called intermediation.
The economic gain for the simple bank is that it brings many Mr. A’s and many Ms. B’s together, monitors the risks and ensures that both can withdraw from their part of the deal easier than if they had entered into a direct contract with one another. The more people Ms. B’s bank lends to (diversification), the lower the impact on Mr. A if a single Ms. B is unable to make payments on the contract.
Additionally, a bank is probably better able to judge a borrower’s credit quality and to monitor it closely. As this leads to a lower risk for Mr. A, he will be satisfied with a lower interest rate on his bank deposit than he would have charged Ms. B in a direct contract. As a consequence, Ms. B is able to borrow at lower costs, which supports her in growing her business.
To allow withdrawals of deposits at any time and to stand ready to issue new loans, a bank has to hold a certain amount of cash. In the early days, banks often quickly collapsed when they incurred higher than expected loans losses and could not cover all deposits. Therefore, government regulators require that banks hold a minimum amount of equity capital to absorb potential losses and protect depositors. As shareholders are affected by losses first, they require the bank to lend only to borrowers of adequate credit quality and to demand a reasonable interest rate for the expected risk of payment shortfalls (risk-adjusted pricing). This is the basis for all risk management systems. If the bank earns more interest than it pays out and covers its other costs, the remaining income is available to compensate shareholders for their investment risk.
Not All Banks Are Created Equal
The business profiles of banks often differ. Below, we consider three different business profiles, the Retail Bank, the Diversified Bank and the Investment Bank.
The Retail Bank has a regional focus and does its business primarily with private clients and corporations. It has a strong focus on lending, primarily residential mortgages and corporate loans. It does not offer investment banking services and trades only in a limited number of local stocks and bonds. Its presence in international capital markets is minimal.
The Diversified Bank is active internationally and offers the full range of banking products to private clients and corporations. Besides traditional lending, it also offers professional portfolio management and investment banking services. It trades in a wide variety of securities globally and uses global capital markets for refinancing.
The Investment Bank focuses on institutional investors globally and takes in very few savings deposits. It is active in managing new issues and provides pricing for a wide range of securities in the global markets as well as individual over-the-counter transactions. It generates fees and commissions by advising companies and financing transactions.