How do banks work?
Dr. Ken Cyree
Fall 2014

• 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

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.

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.

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

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

• 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

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:
Assets
Cash
Liabilities & Equity
$100,000 Liabilities
Equity
$0
$100,000

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.

How do banks work?
• We have the following:
Assets
Cash
Reserves
Loans
Total Assets
Liabilities & Equity
$70,000 Demand Deposits
$10,000 Equity
$20,000
$20,000
$80,000
$100,000 Total Liab. & Equity $100,000
• Note that we transformed assets from cash to a loan.

• 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:
Interest Income
Interest Expense
Salaries
Other Expenses
Net Profit
$10,000
$0
$0
$0
$10,000
• And we did not have any expenses!

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:
Assets
Cash
Reserves
Loans
Total Assets
Liabilities & Equity
$10,000 Demand Deposits
$10,000 Savings
$1,060,000 Equity
$1,080,000 Total Liab. & Eq.
$500,000
$500,000
$80,000
$1,080,000

• 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:
Interest Income
Interest Expense
Salaries
Other Expenses
Net Profit
$106,000
$5,000
$20,000
$0
$81,000
• But we do not have a building or any other expenses! Making money is tough in a bank.

How do banks work?
• In our prior example, let’s review the assumptions and see if there are any possible problems
1. We can earn 10% on loans. Is this realistic? If so, what kind of loans are they?
2.
We had no other expenses than a teller’s salary and interest. Realistic?
3. All the savings and checking (DDs) stay put. Is this realistic?

• What if a $100,000 loan fails. We would lose the interest (an opportunity cost) and the investment in the loan:
Interest Income
Interest Expense
Loan Losses
Salaries
Other Expenses
Net Profit
$96,000
$5,000
$100,000
$20,000
$0
-$29,000
• 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

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?
Assets
Cash
Reserves
Loans
Total Assets
Liabilities & Equity
$0 Demand Deposits
$0 Savings
$1,060,000 Equity
$1,060,000 Total Liab. & Eq.
$480,000
$500,000
$80,000
$1,060,000

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.

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%.