🏦Banks and how they earn money

Flows of Fund (Centralised Application)

Why do we need savings?

Saving gives a sense of safety during uncertainty, during a centralized application this was amplified by the existence of PIDM or Federal Deposit Insurance Corporation in the event of the bank or FIAT centralized authority going bankrupt.

BANK capitalizes this by acting as the centralized authority in accumulating savings from savers such as:-

  1. Household Savings

  2. Business Excess Cash

  3. Government Expenditure Surplus

in return for a marginal savings rate of around 0.5% - 2% interest rate.

The accumulated savings from the bank will conduct fractionalized lending, by holding only a portion of the money deposited with them as a reserve. The bank use customer deposits to make new loan and award interest (Savings rate) on the deposits made by their customer.

The subtotal in the diagram represents the total Deposit in the bank, in this case, representing USD 100,000.

Because these deposits needed to be paid back in the future and are often interest bearing they are regarded as Liabilities.

Banks then utilized a portion of these deposits (≥90%) as interest-bearing loans (typically 3-6%), so in this case, this would turn to transform the monies deposited into Assets, USD 90,000. While the remainder will act as a capital requirement for the bank to meet the depositor's future withdrawal.

How do banks earn money? (Retail Banks)

The difference between the interest rate between Loan IR and Savings IR would be the net Interest Income for the bank. (IR = Interest Rate)

Given that the saving is not controllable, while the SavingIR is typically lower than the feds fund rate they are generally stable. While the total loan amount is dependable on the total saving deposited.

In layman's terms:

  1. Interest on loans (LoanIR) : When a bank makes a loan to a customer, it charges interest on the loan.

  2. Interest on deposits (SavingsIR): Banks also pay interest on deposits that customers make into their accounts.

  3. Earning the difference between interest on loans and deposits

Why are loans crucial?

Loans are often crucial for corporate because this would improve the following:

  1. Business Expansion

  2. Growing Project

  3. Improving cash flow for personal and corporate

  4. Improving term for a larger amount in the future.

🙈Problem Arise

Moral Hazard

Banks are required to maintain certain ratios of capital to assets, as prescribed by regulatory agencies such as the Federal Reserve. We call Statutory Reserve Requirement (SRR). These ratios are designed to ensure that banks have sufficient capital to absorb losses and meet their financial obligations. If a bank were to lend more than what is required by these regulatory ratios, it could potentially put the bank in a risky financial position, as it may not have enough capital to cover potential losses on the loans.

However, it is important to note that while banks are required to maintain certain capital ratios, they are also in business to make profits. As such, they may choose to lend more than what is strictly required by regulatory capital ratios in order to generate additional revenue from interest on the loans.

Adverse Selection

Adverse selection occurs when there’s a lack of symmetric information prior to a deal between a buyer and seller.

This lesser information often leads to higher risk for the lender / Bank.

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