What a Bank Does,
Or: How I Learned to Stop Worrying and Love My Financial Institution
By James Bezerra
While there are endless variations and permutations of banks and the services they provide, all banks essentially do two things: they take in money and then give it out again. There is no mystery to it at all.
Person A deposits her paycheck into her bank account and when she wants some of that money back, she removes it to do with as she pleases, to buy sewing notions or drug paraphernalia, or whatever. To the average person there is no mystery at all. A bank is just a warehouse where money is kept safe from bandits, muggers, and water damage.
If Person A is particularly astute, she might one day ask, “How does the bank afford such a nice building if all it does is charge me five bucks a month for my account?” And then she might think to herself, “Well from other people’s interest, of course!” and then go about her day, though she is only partially correct.
What would likely never occur to Person A, is that banks are not service institutions. They do not exist to make modern life easier. They exist to make money.
When Person A deposits her paycheck, what follows is an intricate and complicated ballet of movements, none of which are ever seen by Person A.
The bank takes Person A’s money and puts it into a massive pool of money, along with money from Person B and Person C and Person D, etc., ad infinitum.
The bank keeps a small portion of ALL THAT MONEY available in case Person A needs to withdraw some to pay off a gambling debt or in case Person B wants to buy some dirty lingerie on her debit card. But aside from those sorts of things, most of ALL THAT MONEY would just be sitting there all the time gathering dust; except that banks are not warehouses for money.
So what a bank actually does is spend most of that money on other things (which have nothing to do with Person A or Person B or Person C, etc.) A loan is a good example of this. If the bank takes $100 of Person A’s money and gives it as a loan to Person X, then Person X is generally required to pay back that loan with interest. If the interest is $1 a year and Person X pays back the loan after one year, then Person X has paid back $101 to the bank. And remember, $100 of that technically belongs to Person A, but the bank has made $1 just for loaning out money that never belonged to it in the first place! And Person A never even knew about it!
But what happens if Person A wants all of her money back all at once even though the bank has loaned it all out?
Well that’s okay. The bank - much like any good casino - has kept enough money on hand (from Person B and Person C and Person D, etc.) to give Person A back all her money.
But what happens if ALL the people want ALL of the money back ALL at once?
Well that is called a “run on the bank” and it will cause a bank to “collapse”, because the bank does not actually have ALL THAT MONEY anymore.
However, every single bank that has ever existed throughout all of human history - going back to the de Medicis who basically invented modern banking in Florence and then funded the Renaissance - has functioned on the fundamental principle that there will never be a time when ALL the people want ALL the money back ALL at once. Every single bank in existence today (including the one where you keep your money) has made this assumption, even though the assumption has been proved wrong virtually constantly for over 500 years.
Fundamentally, however, Person A and Person B and Person C all understand that banks loan money. It is even likely that Person A has a home loan, Person B has a student loan, Person C has a car loan, etc. The implied contract that exists between banks and the people who use them is that the banks will behave in a thoughtful and responsible enough way that everyone involved is able to benefit from the relationship. Even though this implied contract has been violated over and over again for more than 500 years.
These are all oversimplifications. Sort of.
No where on earth is there a bank that would make a $100 loan with an annual interest rate of 1%, because banks are not in the business of making only one dollar a year. Banks (and by extension, all investment firms, hedge funds, lending and financial institutions, etc.) are primarily in the business of making VERY LARGE sums of money.
Well now you want to know: How does a bank (or any other financial institution) do that?
Oh there are lots of ways! And new ones are being invented all the time!
Very large banks (like the one you probably use) like to deal with other very large organizations, like other large banks, countries, or oil companies. If a large oil company wants to build a series of oil rigs in the Gulf of Mexico – for instance – it will go to a very large bank and take out a very large loan for hundreds of million dollars. The bank is happy to do this because it will make a lot of money on the interest from a loan like that. Also, a big oil company is often willing to cut the bank in on an extra share of the oil profits. The oil company is willing to be so generous because lots of times the same people run both the oil companies and the banks. How convenient is that?!
Other times a very large bank will work with a foreign country (usually a poor one that has oil or diamonds) and will make loans to the otherwise poor government in return for largely untraceable repayment in the form of raw goods like oil or diamonds. This is good for the bank because it generally gets to dictate the terms of the repayment (since the bank has the money and the country does not). So instead of a 1% annual interest, sometimes banks can charge a 100% effective interest rate! Because a lot of times the bank gets to decide how much the oil or diamonds are worth as a form or repayment, regardless of market price. How good for them! But why would any country want to pay a 100% effective interest rate on a loan when it could just sell its own oil and diamonds?
Well, sometimes the country can’t. Sometimes other organizations – like “the United Nations” – won’t let the country sell its goods on the open market. That is called an “embargo”. But why would the United Nations “embargo” a country’s oil or diamonds? Well usually because those countries are run by “dictatorships” that commit “human rights abuses” like “operating death squads”, engaging in “mass genocides” or “ethnic cleansings” or “systematic campaigns of rape and terror” or doing things like “kidnapping children” and forcing them to mine diamonds.
But wouldn’t a big bank get in big trouble for doing something like that?
Well sure!
But only if anyone paid any attention or cared, which most people don’t.
Just to be safe, banks do not loan the money directly to these counties. The loans are broken down into numerous smaller amounts and moved through a purposefully complicates series of “front companies” and “shell corporations” and most of those are located in small countries that don’t have very many banking laws. Sometimes the bank will even pay a lot of money (in the form of cash or diamonds or oil or untraceable bearer-bonds) to members of those governments to ensure that they don’t make any new banking laws in their little countries. Have you ever heard of Antigua and Barbuda? You haven’t?! That’s probably because you’re not a bank CEO.
When one of those “embargoed dictatorships” pays the bank back – say with three hundred thousand barrels of oil every week – the bank uses even more “front companies” and “shell corporations” to get that oil out to the market to sell at a much higher “price” than it credits back against the “embargoed dictatorship’s” loans. In this way, a very large bank - like Barclays or HSBC or Credit Suisse, all of which do banking for ISIS - is able to use ALL THAT MONEY that Person A and Person B and Person C, etc. deposited to make massive “profit”. And the bank doesn’t even have to share any of that “profit” with Person A or Person B or Person C, etc. How great is THAT for the bank?!
Those are only a few examples of how smart banks are at making money.
Banks are so smart that they have even figured out that they can make money off the money that they have already loaned out! When a bank makes very large loans and investments, it depletes the money that it has to make new loans and investments (and to pay back Person A and Person B and Person C, etc.). Since the bank has loaned out all that money, all it has now is a bunch of IOUs worth billions and trillions of dollars. So it may not have any money, but it has lots of potential money.
What the bank does then, is roll up all of those IOUs into an “investment opportunity” that other people and companies can buy. This process is called “commoditizing debt”, and the “investment opportunity” is called a “derivative” (named so because it is derived from something else). How exciting!
When a bank (or other financial institution) creates a “derivative” it is sure to mix a lot of unrelated types of IOUs into it (like risky home loans that it wants to get off of its books), that way it is almost impossible for a person or company to know, or even understand, what it is buying. But why would any person or company want to buy a mysterious “derivative”? Usually because the bank or other financial institution has a good track record of making lots of money! And because most of the people who run the “hedge funds” and “investment banks” (which buy most of the “derivatives”) are good friends with the people who run the banks. How convenient!
See, now the banks have managed to take money from Person A and Person B and Person C, etc. and loan it out in ways that will earn the bank lots of extra profit (which it does not have to share with Person A and Person B and Person C, etc.) and at the same time, it has managed to sell off all of its IOUs for real money. It has ended up making extra profit at least two different ways from the original money deposited by Person A and Person B and Person C, etc.! How smart is that?!
But what happens if all of those risky home loans start to go bad because people can’t pay them? And why would a bank make a risky home loan in the first place?
Well once upon a time the United States had some old time-y laws called “Glass-Steagall” (named after Senator Carter Glass and Rep. Henry Steagall). Those laws required banks to hold onto the loans and therefore to hold onto the “exposure” that would be created if a loan went bad. So way back then in the past, a bank only made a loan if it looked like someone could pay it back. Eventually though, all the people who used to run the banks went to work for the government as bank regulators. How convenient! And then the banks lobbied the Congress to repeal those old Glass-Steagall laws, which it did.
Then banks told their loan officers (who get paid bonuses on the number of loans they originate rather than the number of loans that get paid back) that they could make as many loans as they wanted! Almost as soon as the new, risky or “exotic” loans got created and sold to people (mostly people who couldn’t have gotten one before) the banks rolled them into “derivatives” and sold them off to other people who didn’t really understand what they were buying. Everybody was making lots more money!
Except for the people who took out loans they didn’t really understand to buy houses they clearly couldn’t really afford. They weren’t making any more money than before.
Sadly, when all those people started to “default” on their mortgages – millions at a time – all of those IOUs that were rolled up inside of all those “derivatives” went bad, meaning they lost their value (or rather, their potential value). Suddenly big companies and hedge funds and investment banks which thought they had trillions of dollars of potential money, didn’t anymore; they just had “loss” and no real money left.
Once that happened, none of the other banks wanted to loan them any money anymore.
Plus, since so many of the companies were interconnected and laterally invested in each other, no one could be sure anymore who actually had any real money left. So everyone stopped loaning money to everyone else. Then whole banks and investment firms began to “collapse”. And since they were so interconnected with other banks and other investment firms, those other banks and other investment firms began to “collapse”. And for a little while, it looked like the whole world economy was going to “collapse” because no one actually had enough actual money to cover all of the “loss”.
But remember all those people who used to run the banks but then went to work for the government as bank regulators? Well they convinced the United States to give the banks lots of money (called a “bail out”) so that all of the “collapsing” would stop. The government agreed to do that so that “modern human civilization” would not “collapse” and people wouldn’t end up living like characters in a Mad Max movie.
Well those banks took ALL THAT MONEY and they did all the things that banks do to turn money into more money and some of them even paid it back to the government so super fast that it made a lot of people wonder if they even needed a “bail out” in the first place, especially since now the banks were showing phenomenal earnings. How great for them!
From diamond rings to debit cards to gasoline, it sure seems like the banks have it all figured out. Person A can swipe her card for a cup of coffee (the swipe itself makes the bank about two cents) and drive to work in the car the bank helped her get (at a 4.04% interest rate on a 60-month new car loan) to work the job where she makes the money to pay her student loans (at a 4.66% interest rate) before she heads home to the house the bank let’s her live in (at a 3.877% APR on a 30 year fixed mortgage) where she watches the evening news (about Islamic extremists selling Iraqi oil across the Syrian border to Turkish brokers) and feel completely unconnected to any of it (because if she felt otherwise, then the banks might have a problem).
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