Thursday, January 29, 2009

How Does a Bank Work? (Pt 2)

George Bailey is about to have a very bad day.

When was the last time you watched "It's a Wonderful Life"? If it was recently maybe you remember that while the main story is all about George Bailey discovering how much the world would change without him, the underlying conflict is all about banks. George runs a bank, the Bailey Brothers Building and Loan; it was his father and Uncle Billy's business. And it's always just barely scraping by. Meantime, Old Man Potter's got a bank, too, it's the big bank in town, and it has long had its eye set on Bailey Building and Loan.

And early on, before Uncle Billy loses $8000 and drives George to the point of wanting to kill himself -- what the heck was with Uncle Billy, anyway? -- Bailey Brothers' experiences a run on the bank. That is, everyone comes at the same time to get their money out.

Now, if a bank were like a piggy bank, or like a set of safety deposit boxes, this wouldn't be a problem, would it? Because all the money would always be there. But again, banks don't work that way. In fact, by law (set by the Federal Reserve) a bank only has to have 10% of its deposited funds on hand at any time. The rest, it's free to invest, loan out, etc.

Now, I'm guessing -- but I don't know -- if I'm a small bank, PROBABLY I'm going to have more of that money on hand, because it would take a lot less to cause "a situation". Not a run, necessarily, but some uncomfortable moments.

Of course, if and when that were to happen, a bank could call another bank, get a very short term loan to get it through the day, the week, etc.

Many businesses in fact traffic every day in these sorts of loans, called commercial paper, with an exchange of billions of dollars happening. A major part of the problem post-Lehman Brothers has been that this market has dried up. That is, banks have become very unwilling to shell out these sorts of loans to one another and to other businesses, because no one has been confident that these loans -- which like I said are usually standard, no risk loans -- will be paid off. For this reason, some people talk about a liquidity crisis -- that is to say, business don't have the cash (that's the "liquid") which they need just to pay the staff and keep the doors open.

But that's a story for another day... Back to runs: during the Great Depression, there were runs on banks. People literally could not get their money out of their bank. Talk about blowing a hole in your vision of reality. In the wake of that event, in the Banking Act of 1933, the U.S. goverment created the FDIC -- the Federal Deposit Insurance Corporation, which guarantees any money put into any bank, up to $100,000. Which covers a lot of us. (The federal government wasn't the first to experiment with insuring bank deposits; in fact, New York state had been insuring certain deposits as early as 1829. They've always been precocious.)

Now... runs on banks and "It's a Wonderful Life" both lead into the flip side of all this banking material. I don't know about you, but when I put money in the bank I don't think of it as having a social function. But it does. My money isn't just used to make the bank money; it enables other people to buy their first house (or their second or their third), to send their kids to school, to make it through a rough patch. Without knowing it, we're all wonderfully interdependent and supporting one another.

Jimmy Stewart puts it a lot better than I can. Someone says, I'll take mine now. And he says, "Aw, no," (can't you hear him?):
Aw, no, you're thinking of this place all wrong. It's not as if I had the money back in a safe. The money's not here. Well, your money's in Joe's house, that's right next to yours. And in the Kennedy house and Miss Macklin's house. And a hundred others. You're lending them the money to build, and then they're going to pay that back to you as best they can. What are you going to do, foreclose on them?
Here's that scene in full:

Clearly our banks today could use a lot more George Baileys at the helm.

I've got one last point -- "How Banks are Magic" -- but I'll save it for next week.

In the meantime, here's a very funny bank commercial:


Katie and Maeve said...

Jim: I am really enjoying these posts. As a business major, I know a little about banks but it is nice to see banks explained in a kind and thoughtful way. While I do not endorse CEO's getting billion dollar bonuses when there company is losing money, I do not believe that banks and business in general is inherently evil---the vibe I sometimes get from mass media.

corporatebully said...

RBC Bank President Gordon Nixon - Salary $11.73 Million


I'm a commercial fisherman fighting the Royal Bank of Canada (RBC Bank) over a $100,000 loan mistake. I lost my home, fishing vessel and equipment. Help me fight this corporate bully by closing your RBC Bank account.

There was no monthly interest payment date or amount of interest payable per month on my loan agreement. Date of first installment payment (Principal + interest) is approximately 1 year from the signing of my contract.
Demand loan agreements signed by other fishermen around the same time disclosed monthly interest payment dates and interest amounts payable per month.The lending policy for fishermen did change at RBC from one payment (principal + interest) per year for fishing loans to principal paid yearly with interest paid monthly. This lending practice was in place when I approached RBC.
Only problem is the loans officer was a replacement who wasn't familiar with these type of loans. She never informed me verbally or in writing about this new criteria.

Phone or e-mail:
RBC President, Gordon Nixon, Toronto (416)974-6415
RBC Vice President, Sales, Anne Lockie, Toronto (416)974-6821
RBC President, Atlantic Provinces, Greg Grice (902)421-8112 mail
RBC Manager, Cape Breton/Eastern Nova Scotia, Jerry Rankin (902)567-8600
RBC Vice President, Atlantic Provinces, Brian Conway (902)491-4302 mail
RBC Vice President, Halifax Region, Tammy Holland (902)421-8112 mail
RBC Senior Manager, Media & Public Relations, Beja Rodeck (416)974-5506 mail
RBC Ombudsman, Wendy Knight, Toronto, Ontario 1-800-769-2542 mail
Ombudsman for Banking Services & Investments, JoAnne Olafson, Toronto, 1-888-451-4519 mail

"Fighting the Royal Bank of Canada (RBC Bank) one customer at a time"

Jim McDermott, SJ said...

Yikes! Sorry to hear what happened, Corporatebully. Hope you get your money back.

Thanks for the post, Katie! I hope I'm getting the basics right -- me no speak buziness very well.