Fractional Reserve System

Banks, cash flow, Debt, Leverage, Liabilities

When I was a kid, I always wondered how banks operate. Yes I did know they take money from us and lend it to someone on a higher interest, compared to what they give us. The difference in the two helps them make money. Because they allow you to keep the money on “tap” they give almost negligible interest rates. On longer duration deposits they give a slightly higher rate of interest because the chance of the money being asked earlier is reduced.

While this is simple I still could not understand how banks could lend so much money and how defaulters could have so much money with them.

A few years back I was sharing a ride from Indore to Bhopal – two cities in the state of Madhya Pradesh in India – with a banker. During this 4 hour journey, I happened to get talking with him on the same query. His logic partially answered my question.

The logic was that at any point in time the banks don’t allow you to withdraw All the money from a savings bank account. So they will put clauses – that in case you need an ATM facility then you need to maintain a certain amount, if you need a cheque book then you have to maintain a certain minimum amount in the bank, otherwise they penalise you. Due to this there is always money available to the bank even in savings bank deposits which will not go out of the bank in most situations. This becomes one source of low value funds. In addition there are the long duration deposits etc.

This had partially answered my questions but I was still not able to get my mind to understand how these deposits can create such high value lending capabilities for banks.

I don’t know if you have heard this term Fractional Reserve System before. If you have, then the remaining part of the post will be uninteresting to you. I first read about this in the book Second Chance by Robert Kiyosaki. Then I did some research on Google, Wikipedia etc. This got me most of the answers.

So now over and above what the banker above told me, the banks are allowed to lend a “multiple” of their deposits of various kinds. The key word is multiple. To ensure that the banks don’t go “bust” in most countries they have to hold a certain amount of their deposits with a central bank so that there is always a safety net for the depositors in case the debtors default and a bank has a run on their money.

Due to the ability to lend multiples of the deposit rate , say just for argument sake 10 times the deposit rate – if a bank has 1 million retail customers who have to maintain a minimum deposit of $100 then they have $100 million (1m*100) as the amount which would generally always be available to the bank. Now because they are allowed to lend 10 times the deposit rate, they can therefore lend $100m *10 = $1000m.

Since they always get a much higher rate on lending, and they only pay out a much lower level of interest to the depositors, the difference is huge amount of money for the bank. So on the 100m they are paying 2% per annum – which will mean giving out 2m as cumulative interest to the depositors. On the other hand they may lend at 10%. So 10% of $1000m is $100m. So at a gross level the bank has just made $98m using your $100m. I am sure there are other expenses involved, I have used 10 times just for demonstration purposes.

The challenge for the bank is when people default on paying their loans and the amount is much higher than the deposits. Therefore banks ask for collateral to protect their downside.

This was such a huge revelation for me because this is such a huge cash generator. They have so much leverage on the money which you have lent to them with very little liabilities. The key in this is the ability of the bank to have a good process to understand risk on a loan. This is why I now remember in one his interviews Raamdeo Aggarwal of Motilal Oswal, mentioned that if you want to buy the shares of a bank look at their loan underwriting process. The stronger the process the better the bank in getting its money back and the higher the profits.

I get elated when I am able to solve a query which has been at the back of my head for such a long time.

Let me know if you have had Aha moments when a query which has been long standing gets solved.

Till next time then.

Carpe Diem!!!

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