Articles
The second part of a series on financial products and practices takes a swipe at banks
Deposit rates in Hong Kong have fallen to a remarkable 1 basis point. This means that the interest you can expect on the Hong Kong Dollars in your savings account is 0.01% a year. One hundred thousand dollars at that rate would earn HKD10 over twelve months.
This is really as close to zero as you they can get. If you’re like me you probably find this a little frustrating. The stock market is too frightening a place to put my money, as are bonds and mutual funds, not to mention accumulators and derivatives. I’ve lost too much money on these things as it is. So I want to put what is left of my savings in the bank. Once upon a time I do this and feel good about it because I would earn interest. Now it seems like I am just doing the bank a favour by letting them hang on to my money. I don’t get much in return.
So how is this happening? Is taking deposits just a service that the bank provides to punters like you and me, or do banks actually need deposits?
Well the short answer to the second question is yes, banks really need deposits. The basic business model of a commercial bank is to take in money from depositors and lend it out to someone else. The bank makes money by paying less interest to the depositors than it receives from the borrowers. Without deposits there would be no banks.
Let me explain the commercial bank business model with an example. Suppose I want to set up a bank. First I need capital. I still have $10 left over after losing most of my money in the stock market and I use this money to open up Alanson Bank. I’m not going to be able to do much business with just $10, so I try to find some customers by offering to take deposits at 1%. This might not sound like much, but it’s 100 times more than my competitors are offering so I’ve got a good chance at attracting a few depositors.
Let’s say that the editor of Sunday Money, who is tired of the one basis point he is getting on his savings over at his local bank, decides to deposit his life savings of $70 with Alanson Bank. This is improving the situation but I still need a bit more cash so Alanson Bank issues 20 5-year bonds for $1 each with a 2% interest rate. Surprisingly I am able to find 20 investors still happy to buy bank bonds, and now the bank then has my $10, the Sunday Money editor’s $70, and $20 from the bond issue, giving Alanson Bank $100 to play with.
In order to start making some money Alanson Bank then lends out $90 of this money to a guy called Donald who wants to buy an apartment. Alanson bank charges Donald 3% for this loan and takes a mortgage over the apartment.
Alanson Bank’s balance sheet would now look like this:
Assets | ||
- | Cash | $10 |
- | Loan to Donald | $90 |
Liabilities | ||
- | Deposits | $70 |
- | 5-year Bonds $20 | $20 |
Shareholders Equity | $10 | |
Total Liabilities and Shareholders Equity | $100 |
This is the slightly odd thing about bank balance sheets, deposits from customers are called liabilities, and loans are called assets. This is because, from the bank’s point of view, it has a liability to the Sunday Money editor and to its bondholders. Alanson Bank will have to pay this money back at some point.
On the other hand, the loan that Alanson Bank has made to Donald is one of the bank’s assets as Donald owes the money back to the bank, and this asset produces income in the form of interest.
The other thing to note about this balance sheet is that the value of the assets is equal to the value of the liabilities and shareholders equity. The two sides balance, as you would expect a balance sheet to do. This is very important when we get to the part about what can go wrong.
Alanson Bank is very simple, but its balance sheet follows the same rules as every other commercial bank balance sheet. Obviously the numbers are a bit larger and there are a few other items, but the general structure is the same. Some banks will have a greater or smaller proportion of customer deposits to commercial borrowing, but virtually all commercial banks rely heavily on deposits to run their businesses.
And just like in the real world, at Alanson Bank, our cheapest source of funds is our depositors. Local banks might be able to offer 0.01% to you and me, but their bondholders and the sensible large-scale investors who have a choice about where their money goes, they’re going to expect a bit more.
At Alanson bank, we are paying our depositors 1% and our bondholders 2%, but our largest asset, the loan to Donald, is paying us 3%. The difference between these amounts will be our profit at the end of the year. The more interest we can get Donald to pay us, and the less interest we need to pay our depositors, the more money we will make.
So even though we really need our depositors, it’s really not in Alanson Bank’s interest to pay them any interest. In fact, once we work out that no other local bank is offering anything much more than 0.01% on deposits, we will probably write a letter to the Sunday Money editor and tell him that we have adjusted our rates on deposits to 0.01%, thus increasing our profit margin by a huge amount.
Now we can’t actually afford for our depositor to withdraw his deposit since we only have $10 in cash. Obviously the problem is compounded for us as we have just the one depositor, but like most commercial banks, we don’t have enough cash on hand to pay back all of our depositors at once.
So not only do we rely on our depositors to give us money for us to make loans with, we also rely on our depositors not asking for their money back. Not all at once anyway. If all of our depositors were to ask for their money back at the same time we would need to go to the Hong Kong government and ask them to help us out.
So how do we explain to our depositors that we’re not really going to pay them any interest on their savings? Most bankers will talk about the liquidity in the system, or the movements in official lending rates and things like that. The justification that a lot of banks often rely on is that if loan rates reduce then they need to make a corresponding reduction in their deposit rates, thereby ensuring that their margins don’t change quite so much.
At Alanson Bank if we have to reduce our loan rate to Donald from 3% to 2.75% we need to try to make this up somehow. We can’t reduce the interest we pay our bondholders, that’s fixed when we issue the bonds. But we can reduce the interest we pay our depositor to make sure we continue to make as much money as we did before we reduced Donald’s loan rate. This all makes perfect sense from the bank’s point of view, although since we have already reduced our deposit rate to practically nothing we’re going to have to find some other way to save money, perhaps by laying off a few staff.
But really, at the end of the day, it’s a question of supply and demand. If the bank really needs your deposit it will pay you for it. But if you’ve got nowhere else to put your money and no-one else is offering you decent interest rates, then what are you going to do?
You’re not going to put much of your savings into the stock market and you’re probably still wary about buying bonds. And if you’re like me you feel slightly nauseous at the mention of a structured investment product. In fact, the only competition that the local banks really face right now for deposits is the shoe-box under the bed. And although it’s not quite so secure, and offers slightly lower deposit rates than your local bank, it does have the advantage that it won’t send you a whole lot of pointless letters and it’s not going to go bankrupt.
Speaking of going bankrupt, having explained what a bank balance sheet looks like, let me also explain what can go wrong. Or rather what has gone wrong with so many banks lately.
So back at Alanson Bank, suppose that Donald loses his job and is unable to meet payments on his $90 mortgage. Alanson Bank will foreclose and take possession of Donald’s $90 apartment. If the bank can sell it again for $90 there is no problem, but if there has been a downturn in the property market and that apartment is only worth $85 now, this is what that does to Alanson Bank’s balance sheet:
Assets | ||
- | Cash | $10 |
- | Apartment | $85 |
Liabilities | ||
- | Deposits | $70 |
- | 5-year Bonds $20 | $20 |
Shareholders Equity | $5 | |
Total Liabilities and Shareholders Equity | $95 |
What happened? Total Liabilities and Shareholders Equity has to balance with total Assets, so something had to change when Assets shrunk by $5. The deposit amount can’t change because Alanson Bank owes that money to the editor of Sunday Money and the money we owe to bondholders can’t change either. The only think that can change is Shareholders Equity.
So on this deal Alanson Bank lost half of its Shareholders Equity – it’s worth half as much as it used to be. This is a big deal, but things can get a lot worse. If Alanson Bank can only sell that apartment for $80 then Shareholders Equity will be completely wiped out. Any less and the bank doesn’t have enough money to pay back its depositor and bondholders and it is insolvent.
Substitute our mortgage to Donald with a great big bag of Alt-A mortgage backed securities, subprime loans, and dodgy consumer credit and you have the subprime crisis. Shareholders’ equity started approaching zero and governments had to step in to prevent large-scale bankruptcies.
You will of course remember that one of the first things that governments around the world did when they were trying to rescue their banking systems was guarantee deposits. Why was guaranteeing deposits such a big deal?
Because as shareholders’ equity approaches zero, depositors will start to think that they should take their money out of the banks before it is too late. When everyone does this at the same time it’s called a run on the bank and it basically spells death for the institution.
If your depositors abandon you it’s all over. Without depositors there are no banks. Now do you think they would mind just paying us a little bit of interest?
Why banks can't afford to lose depositors’ interest
Sunday, May 31, 2009
