FIN 537 Toolkit How do banks work? Dr. Ken Cyree Fall 2014

What is a bank? Banks are highly regulated financial institutions that deal with money and provide financial services. –We will deal mostly with commercial banks that accept deposits and provide loans Banks are intermediaries between borrowers and savers –Provide asset transformation –Provide financial transactions services

How did banks start? In ancient times, wealth was stored in the form of something valuable such as gold, cattle or grain. However, gold, cattle, and grain are hard to use for transactions. Innovators created paper “claims” or “receipts” against the gold/grain/cattle. Then, merchants and citizens started accepting these claim tickets as payment. Viola! Money was born.

How did banks start? Markets to trade money for a future payout (i.e., a loan) emerged around 3000 BC. In ancient times, either the government, goldsmiths, or religious authorities would provide “banking” services By the 1600s, a pre-runner to modern banking emerged. The first Central Bank started in 1668.

How did banks start? Banks emerged to provide so-called “bank money” that were initially only good in a local area, such as North Mississippi –Many local panics led to bank runs –Eventually, the US created a National Bank in 1791– lots of history here. It’s charter expired in – The Federal Reserve Bank was created in 1913 to be the Central Bank for the US

How did banks start? Banks require a charter from either the Federal authorities (a national bank) or a state authority (a state bank). –They control access to the banking system since not anyone can start a bank. –Why can’t just anyone start a bank? With the right credentials and capital (money invested) you can start a bank

What do banks do? Banks make a profit on the difference between loan and security interest income (and fees) and interest paid on deposits –They have other costs too, such as salaries –They are in business to make acceptable profits. However, they have great impact on the economy at large. They provide “project evaluation” by determining if a businesses prospects are worthy of investing the bank’s money

How do banks work? Let’s look at a simple example of how a modern bank works. Suppose we start a new bank and provide $100,000 in capital. On day one, the bank’s financial position looks like this: AssetsLiabilities & Equity Cash$100,000Liabilities$0 Equity$100,000

How do banks work? We decide to start making loans, and we also create a deposit at the Federal Reserve known as a reserve account so we can offer demand deposits (checking). –We must hold at least 10% of demand deposits in reserve accounts Suppose we make a $20,000 loan and deposit it into the recipient’s checking account. For now, we will use our own equity to fund it.

How do banks work? We have the following: Note that we transformed assets from cash to a loan. AssetsLiabilities & Equity Cash$70,000Demand Deposits$20,000 Reserves$10,000Equity$80,000 Loans$20,000 Total Assets$100,000Total Liab. & Equity$100,000

Note further that if we earned a whopping 10% on our loan, and even if we loaned out all we had, we would only have $10,000 in revenue: And we did not have any expenses! Interest Income$10,000 Interest Expense$0 Salaries$0 Other Expenses$0 Net Profit$10,000

How do banks work? Next, we decide to start getting lots of demand deposits and we also create savings accounts. And, we loan all of it out except $10,000 in cash: AssetsLiabilities & Equity Cash$10,000Demand Deposits$500,000 Reserves$10,000Savings$500,000 Loans$1,060,000Equity$80,000 Total Assets$1,080,000Total Liab. & Eq.$1,080,000

If we pay 1% on our savings and hire a teller for $20,000, we have the following, assuming we still earn 10% on loans: But we do not have a building or any other expenses! Making money is tough in a bank. Interest Income$106,000 Interest Expense$5,000 Salaries$20,000 Other Expenses$0 Net Profit$81,000

How do banks work? In our prior example, let’s review the assumptions and see if there are any possible problems 1.We can earn 10% on loans. Is this realistic? If so, what kind of loans are they? 2.We had no other expenses than a teller’s salary and interest. Realistic? 3.All the savings and checking (DDs) stay put. Is this realistic?

What if a $100,000 loan fails. We would lose the interest (an opportunity cost) and the investment in the loan: We would have to “pay” for it with our equity, and wipe out more than 1/3 of our investment in the start-up bank Interest Income$96,000 Interest Expense$5,000 Loan Losses$100,000 Salaries$20,000 Other Expenses$0 Net Profit-$29,000

How do banks work? We have quite a few more problems to deal with too. For example, what happens when one of our checking account holders writes a $20,000 check to buy a car? AssetsLiabilities & Equity Cash$0Demand Deposits$480,000 Reserves$0Savings$500,000 Loans$1,060,000Equity$80,000 Total Assets$1,060,000Total Liab. & Eq.$1,060,000

How do banks work? In the first case with a bad loan, the bank experienced default risk. In the second case with a person writing a check, the bank experienced liquidity risk Note that the bank also had regulatory risk since they did not have at least 10% in their reserve account either. There are a few more types of risk we will look at during a later class.

How do banks work? So, rather quickly we ran into real trouble with the bank, and we have not even paid ourselves a salary. –What will happen if we use current market rates on loans? –How many people will we need to operate the bank? Certainly more than one teller. –Banking margins are very low. The average pre-tax return on assets in March, 2014 was 1.46%.