FIN 537 Toolkit

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

2. 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

3. 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.

4. 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.

5. 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 1811. • The Federal Reserve Bank was created in 1913 to be the Central Bank for the US

6. 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

7. 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

8. 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:

9. 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.

10. How do banks work? • We have the following: • Note that we transformed assets from cash to a loan.

11. 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!

12. 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:

13. 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.

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

15. 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

16. 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?

17. 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.

18. 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%.