A thought about banks

This is me trying to figure our how banks work.

Money goes into a bank in the form of investor capital and deposits. (I suppose banks can also sell bonds which it you think about it are like a different form of deposit.) The bank also obtains money in the form of deposits. Banks are required by the government to hold money in reserve. A bank can lend out all of the capital and deposits less the reserve it is required to hold. Say the reserve is 10 percent, then a bank can lend out 90 percent of the funds it has obtained.

Banks lend against collateral. Thus a bank can make a loan in the form of a mortgage on your house. It might loan up to 90 percent of the estimated value of the house. If you default on the loan, the bank can foreclose on the mortgage. As long as the money retrieved from the foreclosure covers the remaining amount of the loan, the bank gets its money back, allowing it to cover the value of the deposits it had loaned out without losing capital.

It seems to me that the required reserves held by a bank in part serve to provide a guarantee to the depositors that the collateral of bank loans and the reserves will be sufficient to guarantee the safety of their deposits. When banks make riskier loans (in the sense of financing a larger portion of the value of the collateral) then their reserve rates should be increased.

The interest charged on the loans made by a bank is used in part to pay the interest on the deposits of the bank and the profits on the invested capital. Since the interest that the bank pays on deposits is fixed by the agreement between the bank and the depositor, there is a risk on the rate of return on investment. In general, the bank should be managed so that the return on investment is higher than the interest it pays on deposits, rewarding the investors for the risk they have assumed.

Banks benefit from the statistics of banking. Usually the bank can depend on an accurate prediction of its total amount of deposits because individual new deposits and withdrawals are statistically uncorrelated and the "law of large numbers" holds. Of course, in the past there have been unpredictable fluctuations, leading to runs on banks or periods or rapid increases in total deposits. In part these fluctuations have been based on the psychology of the depositor, and government insurance of bank deposits helps to keep depositors calm and deposits in place.

Banks usually can also depend on the accurate predictions of defaults on loans, allowing them to accurately calculate the required interest rate needed to pay the interest on its deposits and profits on investment even after losses on defaults. Of course, as recent experience indicates, when a real estate bubble bursts the banks may find that they have seriously underestimated the risks of defaults on real estate mortgages. When the economy goes into recession or depression, the banks may find that they have seriously underestimated the risks on loans to businesses. Mortgage insurance can help to reduce such risks of underestimation of default rates. Government programs to keep the economy sound and growing can help to reduce the risks of underestimation of default rates on business loans.

One of the great things about banks is that they help people mobilize their capital. A person can take a mortgage on his/her house or land and use the money to invest in his/her business. If the profits from the investment in the business exceed the cost of the money borrowed, then the person comes out ahead. The economy benefits from increased investment in businesses, resulting in more employment and economic growth. A renter, having saved enough for a down payment on a home, can borrow the rest of the money needed to buy the home. As long as the cost of ownership is less than the cost of rent, he/she comes out ahead. The government, believing that wide spread home ownership has considerable social benefits, can foster investment in home ownership not only be mortgage insurance but also by tax deductions for mortgage interest payments.

The following illustration from How Things Work's article on How Banks Work illustrates how banks multiply the amount of money circulating in the economy. The multiplication of money in the economy if too great is inflationary, if too low is deflationary. As a result the Federal Reserve in the United States and central banks in other countries seek to regulate the rate of money creation by banks.