To understand how banks work, you need a bit of accounting knowledge. It all starts with the balance sheet. A balance sheet is simply a snapshot of a company’s financial position at a particular point in time. A balance sheet is separated into two parts:
The left side, which is everything that the company owns, called assets, and
The right side, which is the company’s obligations, plus the owner’s stake. The company’s obligations are called liabilities, and the owner’s stake is called equity.
The two sides MUST be equal to each other, that is the right and left side are in balance. There is a simple formula for this:
Assets= liabilities + equity.
To illustrate how this works, suppose you were walking down the street and had $40 in cash in your pocket. Your balance sheet would be:
Cash assets: $40 = No liability + $40 in equity. All in balance.
Now suppose that you enter a diner and order a $20 breakfast. Now your balance sheet looks like this:
Cash asset: $40 + $20 in breakfast= $20 liability that you owe to the diner for the breakfast + $40 in cash equity. Still balanced, because you added the meal to your assets, but that meal came with a liability that you now owe to the diner, so Assets still equal liabilities plus equity.
Your meal is done, so you pay your tab. Now your balance sheet looks like this:
Assets $20 in cash= $0 in liabilities + $20 in cash equity. Still balanced. This is all governed by standard rules called GAAP (Generally Accepted Accounting Principles).
Now let’s apply this to lending. I get some investors, and we start a lending institution. They start off by investing $10 million in my company. My balance sheet looks like this:
Assets $10 million in my checking account = $0 liabilities, $10 million in equity.
Now here is where things get interesting. I loan someone $1 million to open a business. Let’s not get into interest rates just yet, because I want to explain how this accounting entry works. Instead, we will do a flat fee. The loan paper says that the borrower has to repay me the $1 million principle, plus a flat fee of $50,000 for the privilege of borrowing this money. This means that my balance sheet will look like this:
Assets are $9,000,000 in my account, plus a promissory note for $1,050,000. My liabilities are $1,000,000 that I owe to the borrower, plus owner’s equity of $9,050,000. Still balanced.
I do this a bunch of times, and now I have assets of $2,000,000 in my account, and notes totaling $8,400,000. For the right side of the sheet, I now have liabilities of $8,000,000 that are in the accounts of my borrowers waiting to be withdrawn, and $2,400,000 in equity.
The borrowers finally all take the money out to fund their businesses, so now my balance sheet looks like:
Assets are $8,400,000 in notes, plus $2,000,000 in cash. The right side is now $0 in liabilities and $10,400,000 in equity. All balanced.
What if, instead of investors, I open my bank ay accepting depositors? OK, let’s see.
Assets= $8,000,000 in deposited money, plus $2,000,000 in owners’ cash = $8,000,000 of liabilities (That deposited money isn’t mine- I still owe it to them), plus $2,000,000 in equity. Balanced. I have lots of funds that I can lend out, so I am said to be liquid.
I make the same loans under the same terms, but this time, it looks different:
Assets are $8,400,000 in notes, plus $8,000,000 in depositor cash, plus $2,000,000 in owners’ cash. We now owe $16,000,000 in liabilities, plus $2,400,000 in equity. So how did we do this? Did we create money out of thin air? How can we have $16 million when all we did was lend out the $8 million that was deposited in our bank? That $16 million is just us counting the same money twice. It doesn’t make sense if you are a concrete numbers person. That’s what is meant by the money multiplier of banks. If you want to look at it as a concrete number, it certainly seems that we have created that money out of thin air. After all, we were given $8 million, but now there is $16 million out there circulating in the economy.
This, to me, was the most difficult part in understanding finance. So how did I get to the point where this made sense?
At the end of the day, we didn’t really create any money. For every dollar we lent out, we still owe a dollar to our depositors. If those people all came to us and wanted their money back, I would be in deep shit. After all, I loaned out their money and I no longer have it. Their money is nothing but a bunch of ledger entries and withdrawal strips. One way to make all of my depositors come to me demanding all of their money at the same time is to have them think that I don’t have enough funds to pay them. That’s called a “bank run” and is a near guarantee of my bank going out of business.
To prevent the scenario where we don’t have enough money to pay depositors’ demands, we keep a percentage of that money still in our hand, and we call that our reserve fund. That way, if one of our depositors came to us and wanted to withdraw his deposit, we have enough on hand to make that happen. The amount that our bank holds back is the reciprocal of the loan to debt ratio (LDR). It’s simple to calculate.
LDR= total loans/total deposits
A healthy bank maintains an LDR of between 70 and 90 percent. If a bank goes below that, they are underutilizing their assets and leaving potential profits on the table, and if they go over that, they risk not having enough funds on hand to pay depositors who want to withdraw money, and thus are risking a bank run and the bankruptcy that comes with it. Banks that go over 100% are lending out more money than they have, and aren’t liquid enough. They are facing a potential crisis.
That LDR is our bank’s reserve. That reserve, being a fraction of my assets, is called fractional reserve.
To be able to lend out more money, we can do some things, and some of them are fraudulent. That’s where the 2009 lending crisis enters the chat. In that case, banks and other lenders were downright committing fraud. This is how the scheme worked:
Let’s say that we want to be more liquid so we can loan out more money. My balance sheet looks like this:
Assets are $10,500,000 in promissory notes and nothing else. I have no more funds. On the right side, I have $10,000,000 in liabilities to my depositors, plus liabilities of $100,000 to my employees, the landlord of my rented business location, the electric company, and others. I have only $400,000 in equity. I need money so I can keep lending because my LDR is 105% and I am in trouble.
So this is what I do- I sell my promissory notes to an investor. I sell them at a discount, and the person buying them makes money on the margin. So let’s say that I sell those notes for $10,250,000. Now my balance sheet looks like:
Assets: $10,250,000 in cash. Liabilities of $10,000,000 to my depositors, and $100,000 liabilities to my other creditors. I now have $150,000 in equity, but now I can loan out more money because my LDR is is back down to 0%. Now I am back in the lending business because someone else owns those loans.
Wash. Rinse. Repeat.
They did this, even though they knew those promissory notes were unlikely to be profitable because they were made to people unlikely to repay them. The people who bought those promissory notes just got screwed. Who bought those notes? Investors- people like you and I when our pension funds and 401k’s were investing in various securities.
That’s where the fraud is, and there were a lot of lenders who took advantage of that. I still can’t believe that no one went to jail over that.
