Ever wonder how a bank works? And why there’s so much money in money?
I once toured London, England, and when the guide announced we were going through the financial district, I thought how much money can be in banking? Boy, was I wrong.
Marginal reserve banking system
Banks get most of their reserves by selling GICs. Reserves also come from personal savings and the money we sometimes keep in our chequing accounts. They then lend out a regulated multiple of these reserves to cash-strapped customers and charge interest.
For example, let’s say a bank has $10 million in reserves and the regulated multiple is 10, they can lend out $100 million. Do a little math and you’ll find that using 3% as both the rate of interest paid and the rate of interest charged on loans, banks generate $3 million in revenue for only $300K in cost. Sure, they have to pay marketing and admin expenses, but that’s a whopping gross margin.
Let’s do the math again, 3% on $10 million in reserves equals $300K product cost. And 3% on $100 million in commercial or retail loans equals $3 million in revenue. What other industry enjoys a 90% gross margin?
The government regulated multiple is very important because the higher it is, the greater the leverage. Before the crash of 2008, the US multiple was upwards of 35. This makes the potential revenue yield $10.5 million for $300K in cost. That’s an extra $7.5 million for the same reserves.
Risk
Okay, okay, so what’s the catch? If customers don’t pay back their loans, the bank incurs a $100 million loss when they have only $10 million in reserves—so they go broke. That’s why banks try to minimize their risk. They only want to lend to people and organizations that’ll pay the money back. And they reinforce this principle by taking legal rights (security) over the assets they finance.
Let’s look at two examples: cars and homes.
Car loans
What do you think happens if you miss a couple payments on your car loan? A truck comes out and hauls away your wheels. Then the bank sells it and puts the proceeds towards the balance of the loan. That’s why banks force you to sign a chattel, giving them the legal right to do this. It’s also why they force you into giving a lump sum deposit (or at least, the first and last month’s payments) up front. This way your loan balance will always be less, or close to, the wholesale value of the car. So if they get stuck with it, they don’t lose.
A vehicle is a security backed loan because there’s something to seize. It’s also preferred because repossessed vehicles are easy to sell. Furniture is another story. Furniture is harder to get rid of and harder to repossess. So banks view these type of loans as riskier. That’s why they charge a higher interest rate for them.
Home mortgages
Now let’s flip to houses. They’re also a security backed loan since the bank can foreclose. That’s when they take your house and sell it, again using the proceeds to pay off the loan. But homes are different because their prices are volatile—they swing both up and down.
Upward swings aren’t a concern because the value of the security is now greater than the loan. It’s downward swings that bother the bank. A large decrease in market value can cause homeowners to “hand back the keys” and walk away from their obligation. And if the home is worth less than the loan, the bank can’t recoup all their investment, so they lose money.
Remember, you can’t go to jail for not paying back a loan. The bank took the risk and charged you a fee. So if the housing market crashes, it’s not your fault. Yes, they can force you into bankruptcy, but that’s not a crime.
Because of this possible downside, banks have additional provisions for mortgages. In Canada, we have CMHC. If you don’t have 20% to put down, CMHC mortgage insurance guarantees this portion of the loan so banks only have to finance 80%. This then gives banks better security since their risk is no more than $80K on a $100K asset.
Fees
Money lending today only equates to half of all bank revenue, the rest comes from fees. And not just the mafia surcharges they hit you with every time you use an ATM, banks are now in the insurance and brokerage businesses.
Entering these markets has not only fueled additional growth for the industry, it’s stabilized the system further to where Canadian banks are seen as relatively safe investments. And that’s why banks stocks are attractive to any investor. (As long as there are no more housing bubbles and everyone pays back their loans.)