What About Banks?

The father of a good friend of mine worked his entire career for one local bank. He would say that banks lend people money that do not need it. Back in the old days before credit cards, banks made loans for cars, homes and would if you had decent credit, lend you money on a 90 day note. I remember walking into Central Trust Bank’s main office on the corner of Fourth and Vine Streets to apply for my first mortgage in June 1970. I was buying a 2-family house, in some parts of the country know as a duplex. The mortgage department was all the way to the back and I walked through several sliding glass doors. I remember standing in front of this man’s desk and telling him I would like to apply for a mortgage. The first question he asked me was, “where is the house?” I said, “Clifton.” Clifton is a neighborhood just north of the downtown and near the University of Cincinnati. He then said, “ north or south of Ludlow Avenue?” I answered, “north of Ludlow Avenue.” Then he said, “have a seat.” I got the loan. I also took advantage of being a veteran, buying the house with no money down. That was 38 years ago next month. I still own that house.

Banks can make money from several ways. The oldest way is for people to deposit their money in demand deposit accounts also known as checking accounts. The Fed permits the bank then to loan a large piece of that demand deposit you have created with your deposit. The Fed requires that the bank hold on to a piece of that deposit and it is because of this reserve requirement that the bank does this. The Fed can raise or lower the reserve requirement depending on the economy. If the Fed wants to encourage economic activity they lower the reserve requirement. If they believe economic activity is too hot they can raise the reserve requirement and by doing this slow down the creation of new loans which leads to more demand deposits.

When the bank makes a loan they create a new demand deposit. This new demand deposit can again be loaned to another borrow, but first the bank must hold back a reserve requirement from that new demand deposit. From one demand deposit of say one million dollars the bank can create several million dollars in demand deposits (loans). This is how banks create money, and this is how the money supply grows. The size of the reserve requirement that is set by the Fed influences the expansion of the money supply and the speed that money moves through the economy. By raising and lower this reserve requirement, the Fed can influence the velocity of money.

If you do not borrow money or you can not borrow money, you have lost the use of a major tool in creating wealth. Borrowing money is leverage, and leverage makes people wealth. In emerging countries today there is such a thing as mirco-lending. This started in India and Bangladesh to give poor women an opportunity to build a small business. Sometimes the loan was for no more than buying a sewing machine and some material to make clothes. From this beginning, the women would make a living a pay back their micro-loan. This program has been very successful and has spread to other parts of the world.

Being able to borrow money is a good thing. The problem arises when the growth rate of the money supply leads to inflation. Inflation is when prices go up and our money buys less. Corporations will raise their prices if their costs go up so they can maintain their profit margin. Oil now costs $130 a barrel, so the price of gas, refined from oil, must also go up. If you own stock in an oil company, you would want them to maintain their profit margin because without earnings there are no dividends and pension funds that pay pensions every month depend of dividends as well as interest income.

Banks also make money from charging fees. Fee business is not as risky as making money on the spread. What is the spread? The spread is the difference between what a bank pays (interest rate) for money and the interest rate they charge the borrower to borrow money. Demand deposits pay very little if anything to the depositor. Saving accounts pay a higher interest rate to depositors. The problem with spread banking is that if interest rates rise, the bank has to offer a higher interest rate to attract new deposits. If a bank finds itself paying a higher interest rate for new deposits than it is receiving on old loans, it is then losing money. Banks are not suppose to lose money. This is a problem for banks that borrow short term funds and make long term loans. Banks hire at least one brainy person that watches over the balance between assets and liabilities. This may be also know as risk management. Before risk management banks got themselves into trouble. It is amazing to me that they still do manage to get themselves into trouble.

To match up loans with deposits that are locked in for a while, banks offer CD’s (certificates of deposits). When a bank needs money to cover a large loan, they will offer a large CD for a specific rate of interest. The spread between the interest rate on the CD and the rate of interest the bank charges on the loan is the spread. If the person pulls their money out of the CD they take an interest rate penalty. The bank then may have to borrow money from another bank until they have sold another CD.

The rate of interest banks lend to each other is known as the Federal Funds rate. This rate of interest is influenced by the Fed. So, you can see that the Fed, our central bank, has a lot to do with interest rates and the growth rate of the money supply. The Fed has several responsibilities, but for me the most important responsibility for the Fed is the integrity of the dollar. Changing the size of the ball in the middle of the game just does not get it for me. Lending money is an important function. Borrowing money and the ability to borrow money leads to the creation of wealth. People that can not borrow or do not want to borrow money should not be penalized for their decision. The playing field is angled too much in favor of the borrower. The bigger the borrower the more the field is tilted in their favor.

The Federal Reserve Bank administers to our monetary policy. People that live from pay check to pay check or on a fixed income like a pension can not afford inflation. Inflation eats into purchasing power and leads the elderly and poor to make difficult choices between food and medicine, heat in the winter and freezing. Monetary policy controls all these things, and people need to know this. Stay tuned.