Financial markets 101: How does a bank work

Let’s start simple.

  • You have 10 dollars. You put them in the bank.
  • At this point, the bank owes you 10 dollars. THEORETICALLY, the banker could pack up your 10 dollars and go, but you trust her not to. To thank you for this trust, the bank promises to pay you 1% interest on this money (for my European compatriots: yes, you might have heard of it from your grandparents or something)
  • KEY POINT: the bank is hoping that you will not need all your money at once.
  • At this point, the bank lends some of these 10 dollars to someone else. It charges this person 5%
  • The bank makes money on the difference between the 1% it pays you and the 5% it receives from its borrowerWhat happens if I need my money?
  • The central banks and other regulators require each bank to keep a buffer of cash available at any point in time. So in the above example, the bank could only lend out 9 of your 10 dollars, and set the rest aside
  • If you need to withdraw, say, 6 dollars, the bank will tap into the deposits of other people.
  • If the buffer is not enough, it will borrow more money to be able to give it to you

I am glad you asked!

  • If the buffer depletes and the bank cannot borrow from anyone else, it will go bankrupt
  • Fret not! Statistically calculated, the buffer should be enough to withstand even harsh “panic” scenarios where all clients rush to the bank to withdraw their money

It SHOULD

Photo by Alice Pasqual on Unsplash

Let’s complicate things

  • There is a chance the bank will not receive the money it has lent out. However, it still needs to give YOU back the money you deposited
  • For this reason, the bank sets aside another little buffer to provide for the loan default. If a loan is deemed very safe, this buffer will be small. If it’s risky, it will be larger. The way this is calculated is rather public
  • It is worth to note that all these regulations were implemented after the 2008 crash. Prior to that, it was basically the Wild West as regards to how much losses each bank should provide for or how much buffer they should keep in their books
  • On the other hand, a bank can ask for a high interest rate to lend to a very risky borrower compared to a low risk one
  • Deciding whether a loan is risky or not is ultimately a human decision and errors occur from time to time
  • This of course drives lending policies of banks. As banks don’t want to waste their depositors’ cash, they will tend to only lend to very safe borrowers, commanding low returns in exchange. In return, they will also give YOU, the depositor, a low interest rate while they try to squeeze their salary out of the measly margin between the two sides on the transaction

How does a bank make money then?

  • On one side, banks try to “cross-sell” tons of additional services on top of the traditional lending business: credit cards, insurance, capital markets and investment banking products
  • On the other side, they shy away from lending to higher risk businesses, overcrowding the top borrowers with very very low prices and leaving the rest underbanked

Ugly business truths you never wanted to ask.