Thursday, January 29, 2009

How Does a Bank Work? (Pt 1)

I never took an economics class in high school or college. I was an English major; I know more about haikus than balance sheets. And these days it really shows. Since the financial crisis hit, I feel like I've been listening to stories in a language I don't understand at all.

Eventually, and in very small chunks, I've been trying to learn something about this foreign country of finance and interest rates and hedge funds. So from time to time I thought I’d do some posts on what I’ve been thinking about and learning, even if my understanding is a wee bit child-like.

Today, the first of two parts on banks. My question: How does a bank work?

I have tended to think of banks as like piggy banks. I put my money there, it sits there until I come for it.

Of course, somehow, magically, it gains money just by being there. Apparently dollars are like bunny rabbits.

Except they’re not. And if banks were just giving us this extra money, they’d be losing money. A bank is not a charity, it’s a business. Even if it’s community organized and focused, it still has an aim at making money.

So how does that happen? It turns out, by moving money around. The truth of the matter is when we go to the bank, we are not making a deposit. We are making a loan. We loan the bank our money, giving them the right to play with it for a little while, with the guarantee that we’ll get it back. And they promise to pay us back interest, on top of that. It's just like any other loan, except really, really flexible. I can go and get my money back anytime I want.

And the bank takes that money we loan them, and they add it to what they’re getting from lots of other people, and then they invest it in something like Treasury bonds, which is guaranteed to pay out, and normally with a rate of interest higher than they said they’d give us.

And they also loan our money out to people, and demand from them a rate of interest higher than what they said they’d pay us. And the rate of interest depends on the risk involved. The higher the risk, the more the bank makes you pay up front each month. (Or at least, that’s how it’s supposed to work. One of the crazy parts of the subprime mortgage crisis is that banks were loaning money even when the risk was too great, or without even assessing what the risk was. You could get a loan without proving you could pay it back, or without even proving you had a job.)

In any case, multiply the loans, and the length of time they take to pay back, and boing, a bank can make lots of money.

And on top of that they charge us fees for activities that don’t cost them much of anything and aren’t really that inconvenient but which we’re willing to pay. It might be nickels and dimes, but it adds up.

Can you remember a time before ATM fees?

Tomorrow -- trust, Jimmy Stewart, magically multiplying money and banks as a means by which we help each other.

But in the meantime, this thought: I don't know about you, but I find it somehow empowering to realize the relationship between me and a bank is not one-way. They may give me a place to put my money, a variety of ways of making money on that money, and a variety of means to access it; they may be able to offer me additional help if and when I need it.

But when I work with them, not only to make a deposit but even to seek a loan, I'm doing them a favor, too.

Probably that's obvious to most of you. But it's pretty exciting for this English major.


mbmoran said...

Jim _ I loved this post and shared it with our bank president ~ we are just excited english majors and everyone else is finaly paying attention to what we do and asking a few important questions about what we should do going forward. Have a great day!

Jim McDermott, SJ said...

MB, Thanks! Just correct when I get it wrong, OK? It's like learning a whole new language and culture!
Good luck with tax season!