Thursday, July 14, 2011

What is a bank?

Over the years I've seen a lot of confusion about what a bank is. Some of this is deliberate on the part of banks -- they'd prefer that customers not know what a bank is. Some of this is just pure ignorance on the part of the general public, which simply doesn't spend any time wondering, "what is a bank?".

So, first of all, let's talk about what a bank is not:

  • A bank is not a safety deposit box. When you deposit money in a bank, it doesn't stay in a vault somewhere, it gets loaned to someone or otherwise invested.
  • A bank is not a charity. They pay you interest on the money you deposit because they've loaned out that money for higher interest, not out of the goodness of their heart.

So let's talk about "deposits". Banks intentionally use that term to imply that your money gets put into a vault. But the actuality is that you are loaning money to the bank. The bank is paying you interest because that's what happens when you loan money to someone -- they pay you interest. Otherwise, why loan your money? The bank is then taking all of these loans that they got from thousands of people, and then lending out the sum total (minus some reserves) to thousands of other people at a higher interest rate. The bank then makes its living on the spread between what it pays for money ( the interest they pay you ), and what they earn on their loans (the interest their borrowers pay).

At this point, the question becomes, if the bank is lending money at 14% to credit card customers, and is paying you 1% for your deposit, why don't you just lend the money directly yourself and earn that 14% yourself? Well, uhm... because 20% of credit card customers default in the course of a year, and if you lent your money to Joe Deadbeat, you'd be out of 100% of your money? By aggregating the money from thousands of people together, each individual only loaned a few pennies to Joe Deadbeat. In short, a bank is a risk aggregation mechanism that reduces the individual risk of your lending money by aggregating your money and spreading it across thousands of loans, so that any single loan defaulting affects you very little (basically a few pennies less interest next month).

Now, note that I'm talking about an idealized version of banks. So... why are banks in trouble now? It's because they diverged from that idealized version of banking, and instead started gambling with your money. Instead of looking for credit-worthy borrowers, they started buying and selling risky securities on the open market. Amongst other risky securities, they bought trillions of dollars worth of collateralized AAA-tranche "liar loans" from non-bank 3rd parties like Countrywide Financial gambling that residential housing was going to increase in value so that when the foreclosure happened, the houses could be sold for more than the value of the loans. They gambled big, *TRILLIONS* of dollars big. And they lost their gamble -- the housing market ran out of willing suckers to overpay for houses, the price of housing plummeted as houses came on the market with nobody to buy them and sat there and sat there and sat there until foreclosure and dump, and they lost their shirts when the liar loans went bad and those collateralized AAA-tranche liar loans became worth pennies on the dollar.

So anyhow, that's the deal. You're not "depositing" your money in a bank. You're loaning your money to a bank. Banks don't tell you that because they want you to think your money's going into a big vault. But of course that's not where it's going -- it's going to buy bundled liar loans. Or was, anyhow -- not anymore, now it's going on deposit at the Federal Reserve because with consumption at modern lows and regulators no longer allowing them to lend money to deadbeats, there's a shortage of credit-worthy people borrowing money.

-- Badtux the Economics Penguin


  1. A bank is the place where people who don't know about credit unions go to.

    Seriously, why do more people use for-profit banks rather than a member-owned credit union? Are they simply less available outside of flyover land or what? 'cause here in the Midwest I have 3-4 different credit unions that I "qualify" for based purely on living/working in the area.

  2. A credit union is just a bank that's membership-owned, Purple. It is still fundamentally a bank.

    Regarding availability of credit unions, it varies based on state. Here in California a state-chartered credit union can serve anybody who lives or works within its county, and there are a dozen credit unions I could join (I'm a member of one of them). In my brother's home state your employer must contract with a credit union to represent them before you're allowed to join as a member. Unfortunately his employer is based in Alaska and he is in a branch office far from Alaska, so being authorized to join an Alaska credit union isn't much of a benefit for him.

    I asked one person why he banked at Big Bank, and he said he traveled regularly and needed to deposit cash money in various cities and while the CU ATM network is pretty widespread, ATM's don't allow depositing cash. I pointed out that CU service centers exist in many cities that will allow you to deposit money regardless of which credit union you belong to. But that apparently didn't satisfy him.

    - Badtux the Member Penguin

  3. Then there's the level of service you get at credit unions vs banks. The people at my credit union are knowledgeable and helpful. However, I've had various experiences with banks over the last few years as I closed out my late father's accounts.

    Small, regional banks: great service. Larger banks: utterly clueless non-service. Dad chose his banks by the CD rates they were offering at the time, so there was quite a spread. But just based on that experience, I would need a really, really good reason to deal with a Big Bank.

  4. Thanks for the post. A basic definition the public should be very familiar with.
    Credit unions aren't immune from bank-like actions either. But I use one - it's pretty much a no-brainer.

  5. Nunya, actually not. The money went from one register entry at the Federal Reserve (the "money printed" register) to another register entry at the Federal Reserve (the Bank of Hong Kong entry, say). The more fundamental issue is that banks are accumulating reserves because a) there is a shortage of qualified borrowers, b) there is an expectation of deflation meaning that the money will be worth more in the future, and c) the Federal Reserve is paying them more interest on the money than they could earn on the open market with the money.

    This issue (banks accumulating reserves) has nothing to do with whether the Fed buys bonds from private entities or buys them directly from the U.S. Treasury. Now, I hear you say, "but if it had gone straight to the U.S. Treasury, at least it would have gone through the economy once before ending up back in reserves." But MONEY IS FUNGIBLE. The money to buy bonds comes from the Federal Reserve either way. Here is the current money flow:

    Investor: Withdraws $100K from bank to buy T-bill.
    Bank: Withdraws $100K from Federal Reserve.
    Fed: Prints $100K to bank, gets T-bill in exchange.
    Treasury: Spends $100K in the economy.

    Totals: Banks=+$0, Treasury=$100, Fed has T-bill.

    Here is the money flow if the Fed bought directly from the Treasury:

    Fed: Prints $100K to Treasury, gets T-bill in exchange.
    Treasury: Spends $100K in the economy.

    Totals: Banks=+$0, Treasury=$100K, Fed has T-bill.

    It's the same result either way. 1+2=3 just as much as 1+1+1=3, it's the same total regardless of whether you break it up into more operations or not.

    - Badtux the Numbers Penguin

  6. Oh yeah, why QE2 failed -- it was a) way too small, and b) did nothing to incentivate banks to move money out of the Fed and back into the economy. If the Fed started *penalizing* banks for having excess reserves, rather than *paying* banks, QE2 might have actually worked. As it stands, it was like pushing on a string.

    - Badtux the Stringy Penguin

  7. I'm Finally catching up and would like to know if I can post this (with credit to you) on G+

    Did you see the f;Floridian that misses the crook in chief


Ground rules: Comments that consist solely of insults, fact-free talking points, are off-topic, or simply spam the same argument over and over will be deleted. The penguin is the only one allowed to be an ass here. All viewpoints, however, are welcomed, even if I disagree vehemently with you.

WARNING: You are entitled to create your own arguments, but you are NOT entitled to create your own facts. If you spew scientific denialism, or insist that the sky is purple, or otherwise insist that your made-up universe of pink unicorns and cotton candy trees is "real", well -- expect the banhammer.

Note: Only a member of this blog may post a comment.