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The banking industry: How does a bank work

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05/16/2018 | 12:20pm CEST

Broadly speaking, the way a bank works isn’t very difficult to understand: just like at all other companies, we see assets on the balance-sheet (capital that’s been loaned and that generates an interest) and liabilities (capital that’s been borrowed and costs interest).

The assets (that what the bank possesses, meaning the capital loaned) consists most of the time of cash, short-term loans to other banks, loans made to clients (retail customers, companies, communities, etc.), securities (mainly government bonds), sometimes real estate as well as other assets of all sorts (usually confiscated after the bankruptcy of a borrower).

The liabilities (that what the bank owns third parties, meaning the borrowed capital) consists of customer deposits (mainly), and short-term loans (to other banks via the interbank market and to the central bank) and more long-term loans (usually taken out in the bond market). 

Just like a mining company that pockets the difference between a production price and a selling price, a bank is a ‘spread business’ : it pockets the difference between the profitability of its loaned capital (the interests its borrowers pay) and the cost of its borrowed capital (the interests that it has to pay its depositors and creditors).  

This spread is the net interest margin or NIM. A bank’s first job is thus to do this lending-borrowing in a way that’s as profitable as possible.

This interest margin is then completed by revenue other than interests: management fees, administration fees, operating fees, various commissions (paid for example over strong margin activities such as wealth management), etc.

We then subtract all the administrative costs, the provisions for defaulting loans, taxes, diverse and varied adjustments, in order to get the net profit. Of course, all of this remains very theoretical and roughly presented. 

The leverage of a financial balance sheet is also very important. Since the liabilities typically are ten times higher than the equity (and even up to sixty times higher before the subprime crisis!), the returns on assets are sublimated, but the risks are similarly multiplied, and the capital of the shareholders is put at risk at the slightest failure. 

In order to prosper, a bank has to make sure it manages its capital carefully, for example by avoiding to give mortgages to insolvent households. After all, being leveraged by ten means that wiping out 10% of your assets costs your shareholders 100% of their capital.

A bank also always has to monitor its liquidity, in order to persevere its capacity to honor its financial obligations. When banks are in financial difficulty we don’t say that they’re going bankrupt by the way - they just become insolvent.

The banking industry is highly cyclical: during a growth phase the economic actors need capital to finance their projects (households for consumption, businesses to further develop, etc.) and the banks aggressively lend them money - at the most competitive rates possible - to conquer market share compared to their rivals.   

This is why investors tend to consider an investment in a bank like a proxy for the growth of a geography or a particular sector.  

During a difficult economic climate, many borrowers default and/or have to restructure their debts. Since the latter form the banks’ assets (the liability of the borrower is the asset of the lender), banks find themselves forced to erase a part of their assets, and may as a consequence find themselves….. in an insolvency situation (because the incoming money flows don’t cover the outgoing money flows anymore).   

The risk incurred in these situations is multiplied in case of a bank run - when the bank’s clients flock to take out their deposits. That’s when we talk about banking panic, and in that case, a recapitalization imposes itself urgently : this is exactly what happened in Greece in 2015, following the election of Mr. Tsipras.    

Translated from the original article.

Stocks mentioned in the article
ChangeLast1st jan.
BANK OF AMERICA -0.93% 30.74 Delayed Quote.4.13%
CITIGROUP -0.42% 73.84 Delayed Quote.-0.35%
DBS GROUP HOLDINGS LTD -0.77% 25.83 End-of-day quote.3.65%
WELLS FARGO -1.33% 54.26 Delayed Quote.-9.36%

Neelie Verlinden
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