How Do Banks Work?
Depending on whom you ask, the chief culprit for the credit crisis is either risky subprime mortgages or overleveraged banks. In reality, it was a perfect cocktail of both going awry in unison, but today I spent a lot of time thinking about the bank portion.
It started with reading Matthew Yglesias quote from Paul Krugman’s economic textbook, Macroeconomics. Krugman asks the reader about a hypothetical situation in the banking industry that should have been prevented by modern banking regulations. Yglesias wryly notes:
Having read the chapter, the correct answer is that modern banking regulations involve capital requirements that don’t let you do this. Having watched the past six months unfold, the real answer seems to be “not very well!”
I laughed out loud at this post: the textbook gives a clearly outlandish example that should easily be prevented by banking regulations, but the example sounds eerily reminiscent to what is currently happening.
I realized I don’t really understand some of how banks work - what are capital requirements for banks? How do most banks actually make money?
A timely post by Felix Salmon explores just this. You have to understand the
difference between funding and capital. Banks need both, but it’s important to distinguish their cost of funds from their cost of capital.
A bank’s cost of funds is the interest rate at which it can borrow money.
But banks also need capital. If I take your $1,000 deposit at 1% and lend it to Joe the plumber at 7% so that he can buy his business, that’s great, I’m making lots of money on the spread. But Joe’s only going to pay me back slowly over the course of many years, while you can demand your $1,000 at any time. So I need some capital lying around for the depositors to have access to.
Felix’s post provides a few excellent examples that clarify how the banks are supposed to make money.But it is clear our regulatory system has gotten so out of balance that we’re experiencing first-hand the outlandish examples of economics textbooks.
