robert kiyosaki

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!!!

Using debt to grow rich

cash flow, Debt, Liabilities, possibility thinking

I had written two posts a few days back on the difference between debt and liability.

As a middle class person, the word debt has a lot of negative ideas. I have had so much credit card debt , housing loans etc. that the very idea of taking a loan or using a credit card is an absolute no-no.

Garrett Gunderson gave a very good explanation of debt versus liability which I explained in the posts earlier. I also wrote in those posts how I am trying to get my head around the ideas of utilising loans – loosely called debt to grow. I did understand the concept that if you are buying a productive asset, to buy that asset you will incur a liability. As long as your assets are more than your liabilities, its not debt. If you invest in productive assets and those assets generate cash to take care of the liability then there’s absolutely no problem.

I came across one video of Robert Kiyosaki – of Rich Dad Poor Dad fame – where he talks about how the rich actually love debt. But he makes a very clear distinction. They have teams who understand and manage the debt such that they are consistently extracting the maximum out of the asset to produce cash and pay off the debt.

This way they are able to grow their assets much faster. They then use the assets to generate more cash, pay of the liabilities / debt and start the cycle all over again. Since they now also have the asset, they are also able to use that asset as collateral to get more loans to expand further. If the assets are non-depreciating like real estate or intellectual property then its even better. What this gives the rich people is leverage to grow faster. it allows possibility thinking. Therefore the rich are growing richer.

This is something which I need to think of, because my middle class mindset is still a little sceptical. Robert also has a caveat to this theory. He is clear that its not ok for everyone to use debt because its a double edged sword. If you don’t have the guts to handle this kind of a double edged sword, then you should avoid debt at all costs.

Tell me your views on the topic in the comments section below. I will look forward to hearing from you.

Till next time then.

Carpe Diem!!!

There is nothing sexy in achieving financial freedom – part 2

Financial Independence, Uncategorized

Yesterday I wrote about how most of these Ultra rich people – Warren Buffet, Tony Robbins, Richard Koch, Robert Kiyosaki – actually followed a system rigorously even when there were roadblocks around the way

The systems required that they had to do some amount of sacrifices. Maybe they did not go out for a date when they were young because they had to ensure that they were closing something as part of their system.

I also realised when I started a bank mandate initially with just a 1000 rupees. Initially it did matter that even before I could utilise the money, the money went out from the bank. But slowly I got used to it and I went on increasing my commitments to the money getting directly debited from the bank into some Investments.

In 3 years I did not realise what a difference that had made to my financial stability. Based on the possibilities that my investments could do, I actually sat down to figure out a date by which if my assets reached a given value I could leave my job and start doing what I want.

While God has been kind in a lot of these endeavours it is also a matter of the systems working and the investments compounding in the background.

For all those young guys if they read this, just a very small portion of their income if they can directly give a bank mandate, for money to be deducted to go into an investment, without they realising, they can all become millionaires.

If you leave it to your discretion that every month you will invest based on what you save…. You will never be able to invest.

The human brain was designed to ensure that it survived and immediate gratification was more important than long term safety. Hence the brain does not allow you to take a chance with your safety of money and wants you to have it till the last moment. But when you have a system to automatically reduce the money from your bank for an investment the brain gets used to the lesser amount of money and you are able to live a similar Lifestyle even with that less money.

Today there are possibilities of various kinds depending on your appetite and the goals that you have to invest in mutual funds in SAP or in a recurring deposit whichever way you want.

Whatever you do and whatever your risk appetite, put a system in place so that it works in the background and gets you to your goal

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Why you SHOULD buy a house

Financial Independence, Uncategorized

What a contradiction….

Last time I gave you all the reasons of why buying a house (in India especially) did not make sense.

I have a friend Sanjay, who almost 27 years back had given me a very nice philosophy, which I did not heed. But the older I have grown the more I have realised, his was a better thought process.

He used to say ‘ pehle dukaan phir makaan’.  For those of you who don’t understand Hindi, it means….if you have some money, first buy a shop (invest in a business), because once the business succeeds it will generate so much money that you can buy many more houses or larger houses.  The fundamental issue over here being that if you have money and can invest in a productive asset which can supplement your cashflow then building assets and creating wealth become even more easy.

A real life example of this was the landlord of our office in Gurgaon.  He had 7-8 properties which he had rented out to offices.  Each of those properties was getting him a passive income which he was utilising to buy even more properties and he did not need to work.

I would strongly recommend reading Robert Kiyosaki’s  book “Rich Dad Poor Dad”. It  talks of a similar philosophy where cash flow (passive income) is important if you want to create wealth.

So coming to the topic of this blog….you Should buy a house if you can give it on rent and get passive income. You Should buy a house in a locality where businesses and a young migrant population are growing.  From that income you could buy more houses.

Most young people in the technology and services industry today carry home huge bonuses if their company succeeds.  Utilise a portion of that money to put in an asset which can give you passive income.  Once the passive income starts you get the opportunity to start thinking in ways of growing your wealth.

Till next time then…think your way to financial freedom through Passive Income!!!