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The Economics of Banking 101

Article · May 2018

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Saturday, November 09, 2019

The Economics of Banking 101

https://www.linkedin.com/pulse/economics-banking-101-roman-zytek/

by Roman Zytek

Over my twenty-five year career in finance, I noted some lack of understanding of why
banks pay next to nothing on deposits but charge exorbitant interest rates and fees on
loans. A poor understanding of this phenomenon has been particularly strong among
policymakers and activists who often argue in favour of interest rate ceilings and
targeted credit quotas as magic solutions to ease access to finance for their favoured
constituencies such as micro and small businesses.

In this note, I explain this intriguing phenomenon and provide hints on how to reduce
the cost of credit to deserving borrowers and keep the financial system sound and
public treasury safe. For a more detailed discussion of the plethora of measures to
reduce borrowing costs, policymakers, bankers and the public can turn to my note
“How to Reduce Borrowing Costs and Make Banks Happier,” available on request.

The Sweet Side of Being a Bank Shareholder

Banks turn a special type of deposits and investor-shareholder capital into loans. In
most banks, the deposits-to-capital ratio is close to 10 but it can vary from 4-1 to 20-1.
A shareholder who puts $1 into a bank's capital can use from $4 to $20 worth of
depositors' money to make loans. Bank shareholders put just a bit of own money to
gain control of lots of depositors', other people's money. As a result, even a modest 10
per cent return on a $10 loan ($1 return) will double shareholders’ money in an entity
where $1 in capital controls $9 of deposits, absent operating costs and loan losses.

[(Loans of $10)*(Interest of 10%)]/(Capital of $1)=1/1 (a 100 per cent return on

investment).

Even if the bank pays depositors 2 per cent on their $9 in deposits, the shareholder still
could get 82 per cent return on investment, absent operating costs and losses.

(10*0.1-9*0.02)/1=(1-0.18)/1=0.82/1=0.82 or 82 per cent.

The Pervasive Conflict of Interest: Bank Shareholders, Depositors, and Taxpayers

Deposits placed with banks are special because when people and companies put
money into a bank they expect a guarantee they will get it all back. Today, many
countries explicitly or implicitly guarantee the nominal value of deposits placed with
banks. In some countries, at times, governments guaranteed even the real value of
deposits, their purchasing power.

The special characteristics of bank deposits – a commitment to safety -- and the special
characteristics of bank capital – a commitment to risk -- make the relationship bound to
Saturday, November 09, 2019

fail from day one. On the one hand, people who deposit money in banks want safety
first and above all. Their bank deposits are supposed to be the safest asset in their
saving portfolio. On the other hand, people who invest money in bank capital look for
most leverage possible. Their investment in bank capital (shares) often represents the
riskiest asset in their diversified portfolio.

A marriage between a financially conservative spouse and a risk-loving gambler is

hardly sustainable absent intense outside counselling. Similarly, the bank investor-
depositor relationship is unsustainable without government oversight. As a result, bank
shareholders have no choice but to submit themselves to heavy regulations, which can
turn sour the otherwise sweet deal of controlling other people’s money with little own
money. Bank regulators rightly argue that people who want to put their money at risk
to earn higher returns can buy high yield bonds, popularly known as junk bonds, near
equities (convertible bonds) or equities (stocks) and their various incarnations, such as
mutual funds (unit trusts) or exchange-traded funds (ETFs). They can also buy bank
stocks and become bank risk-loving shareholders.

The Sour Side of Being a Bank Shareholder

Investors in banks, like gamblers, not only can make a lot of money by using tiny
investments to lend other people’s money. They can, and periodically do, lose a lot of
money, their own, their bank depositors’ and their national, and increasingly
international taxpayers’ money.

For example, an investor who puts $1 to control $9 in interest-free deposits can have
his $1 investment wiped out even if the bank charges 10 per cent to lend $10. Absent
any operating costs, the investor can lose all the capital if the borrowers of the bank's
money fail to repay just $1.82 of the $10 loan portfolio.

In practice, given even low deposit and operating costs, a loss of a very small
percentage of loans can wipe out the bank's capital. The most efficient banks spend
about half of their net interest income to cover employee salaries, utilities, office rents,
security, equipment, and numerous other expenses.

If the bank pays depositors 2 per cent, our investor would lose all his investment if only
$1.34 out of $10 in loans turned bad, i.e., the bank's non-performing loan-to-deposit
ratio reached just under 15 per cent. To get a decent return on a risky investment, say
just 6 per cent, the bank would need to charge at least 34.5 per cent on the remaining
85 per cent of the loans it made. Of course, at such prohibitive rates, our bank would be
lucky to have only 15 per cent of its loans turn bad. It would be very difficult to attract
any borrowers except for the true deadbeats who are unable to find lenders among
 Saturday, November 09, 2019

banks that grant loans only to safe, reputable borrowers who sport ‘spic and span’
credit histories and well-cushioned cash flows.

The problem, most often missed by bank critics, is the fact that under competitive
conditions, any $1 in bank losses means an immediate decline in bank capital by $1. If
bank capital accounts for 10 per cent of the bank's balance sheet, a loss of $1 requires
the bank to earn back the lost $1 before its shareholders can enjoy any profit.

Not surprisingly, the first thing shareholders do when faced with a capital shortfall is cut
costs to raise profits on the outstanding loan portfolio. The second thing they do is
push management to either gamble, venture into ever riskier lending to recover the
losses fast or go bust or withdraw from risky lending altogether to rebuild the bank’s
capital at a snail’s pace.

In the meantime, other banks that kept it safe, have not suffered losses, expand by
attracting deposits from the loss-making bank and skim the best, safest clients by
offering highly competitive loan rates. In a competitive world, absent government
intervention to save the “too-large-or-politically-important-to-fail” banks, any bank that
suffers losses would have only a remote chance of ever recovering.

Conclusion

Banks charge borrowers as much as they can get away with to ensure own survival.
However, the total borrowing costs can fall. They will fall (1) when the banking sector's
operating expenses decline; (2) when the overall loan repayment rates improve; or (3)
when the banks' ability to price risk of each borrower and loan accurately improves.

Competitive markets, in particular, the freedom of market entry, gradually put

downward pressure on operating costs. Smarter regulations and supervision do cut
costs, too. A steady improvement in the quality of borrowers that comes with improving
human capital and socio-economic development improve the repayment rates.
Measures to improve the granularity of borrower and loan information help improve
loan risk assessments and pricing, impose higher borrowing costs on riskier borrowers
and loans and reduce borrowing costs to sounder borrowers. As a result, the average
borrowing costs are likely to decline as fairer pricing attracts safer borrowers and repels
riskier borrowers.

Sometimes a decline in the bank lending costs could be socially undesirable. For
example, if it is the result of financial repression, regulations that lead to suboptimal
allocation of savings, or implicit government subsidies that favour bank lending over
more desirable forms of financing, such as equity for start-ups and young firms that are
in desperate need of managerial capital, which is more likely to be provided by private
equity investors than banks.

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