Industry sign banking missouri presentation computer
what we want to do now is turn our attentions to the business of banking a little bit more specific we talked about this sort of general banking environment or the climate and now we want to get down to the business of banking itself what do banks do let's start off by just using this term banks are financial intermediaries there are many different kinds of financial intermediaries each one has its own specialty all financial intermediaries stand between we've got savers and borrowers in a sense they could do business with each other but you remember the problems of asymmetric information transactions cost these sorts of things get in the way of these people doing business with each other not always there are times when direct finance works out but usually the savers and the borrower's don't have direct contact with each other savers give their money to a financial intermediary there's this intermediary middleman and then the intermediary moves it along to the borrower under terms that are favorable to each okay and so anyway dollars in dollars out every financial intermediary same thing dollars in dollars out savings and loans credit unions mutual savings bank insurance companies there's a large number of different types of financial intermediaries they all have their specialty and we happen to be talking about commercial banks the biggest of all the financial intermediaries okay when these dollars come in the dollars go out there's usually some kind of interest that is paid and that is definitely true for banks banks are bringing dollars in and they pay interest on those dollars and then banks send those dollars out and they charge interest for the use of the dollars and so a large part of the story for the bankers is to make sure that the interest they charge is more than the interest they pay okay for example if you're charging let's say 7% and your pain oh I don't know let's say 3% then prospects for the business are pretty good this difference between the two between the cost of funds and then the charge they receive on the use of their funds that interest is known as the net interest margin and since banks like other financial intermediaries specialize in bringing dollars in sending dollars out then the bulk of their earnings comes from that net interest margin now I don't mean to say to you that this is 3% that pay they charge 7 they definitely have a profit because what they have to pay out of that is the rent on the building or if you want you know pay for the building itself you have to pay for the utilities they have to have the building clean you have to pay all the employees all the different expenses that they have are coming out of this there is a little bit of other activities where they're charging a fee for it but this net interest margin I mean we don't just go automatically hey they're making a profit because they have a lot of expenses out of this over the longer term in the banking industry the net interest margin is about 4% and so I use these numbers 3 & 7 here for a particular reason I could have said 13 and 17 but I would keep coming back to a net interest margin of around 4% that's what it is in the banking industry over long stretches of time and the reason for that is that basically they compete for these funds that is to say there are the people the savers that own this money they have many different places - there are many different things they can do with that money and so banks are competing to get it and then when bankers try to loan that the borrowers can get loans from many different places so there's competition there also and so competition is regulating how much the bank has to pay and competitions regulating where the bank can charge and so it's competitive forces that are setting that net interest margin at about four percent okay and so anyway let's talk about this we'll come back to it a little bit more later on I want to start off by talking about this accounting identity because it sort of leads us into the discussion we want to have we're going to talk about the business of banking this accounting identity assets equal liabilities plus me net worth or for banks this is called capital kind of depends on who it is we're talking about this identity and by the way accounting identity I use three I don't even know what you'd call each one of these little horizontal lines but anyway three of those two of them's equal this is an identity this is a definition and what I mean by that is this must be true by the way things are defined it cannot be otherwise okay and though and really what happens is this last item over here will adjust up and down to make sure that this statement is always true that this equality always holds now as I was saying a moment ago this I can't accounting identity it applies to every person it applies to every company it applies to governmental units it applies to banks everybody it applies to okay and assets are the things we own okay so for a bank it owns lots of different things it could own loans those are a key asset of banks it could own some cash it could own some bonds liabilities are what we owe to other people we've got an obligation to give them something back whatever it is that we have that we receive from them we have to return that okay and so if we took everything that we own and converted that to cash you know you take your house your shoes your car your whatever model plane collection your books your stamp collection everything and convert that to dollars we'd have a dollar amount here let's say 150 thousand dollars and then we find out hey what are you and you and you and let's say this is a hundred and ten thousand dollars well then anything that's left over falls into this category and net worth what we normally would say for a person is rather than net worth at your wealth so when we say is somebody wealthy we mean this thing over here and by the way as I was saying before this statement has to be true so if we know this is 115 this one's 110 assets 150 liabilities 110 holy all other people and this has to be 40 right just has to be and so for most people we would say oh that person's wealth is $40,000 for a company we would say oh it's assets are I don't know one hundred fifty million dollars its liabilities 110 million dollars its net worth is 40 million dollars for a bank usually this term would be capital those all mean the same it's that last item over there - laughs whether it's wealth or net worth or capital it mainly depends on whose accounts were looking at okay now there are other statements and accounting other measures of activity that are important there's an income statement and it has to do with the flow of funds through a bank the flow of dollars to or not just a bank but any company but how they're generating revenues what their expenses are what their profits are but this is what they are holding yes sir if you're paying off something well if you let's say you go buy a house I go to the bank I borrow $80,000 by $100,000 house okay and house is in my name so that $100,000 house would be an asset but then my what I owe on that house would be a liability and then the difference would be the part that I own that I paid for out of my own net worth or out of my wealth and that would be in this case $20,000 okay anyway so we've got this accounting identity and it sort of relates back to this little picture I drew a few minutes ago here's the thing this is these are sources of funds and we'll call this uses of funds and so when we come back over to this accounting identity how does a bank get money what are its sources of funds and the answer is on the right-hand side of this identity it gets money from other people and it gets money from owners and so when we say what are the sources of funds for banks owners and then others mmm I'll say depositors and lenders and so when these funds flow into the bank the bank owes this money back right the depositors no longer say here I take this money and the banker says I owe you and when they say I owe you that's a liability are you with me on this the dollars flow into the bank now you owe it back you put money in a bank into the checking account that's a source of dollars for the bank but the bank owes you the other possibility is that the owners of the bank say hey just at first it's some investors and say hey let's go together what start up a bank you've got to come up with some money of your own if you're gonna be an owner of that bank and so this is the bank's capital where we owners contribute something to the bank's operations we're providing funds to that Bank and so now the bank's got dollars coming in from these various sources from the owners and from others and then the bank puts those funds to use here's the uses of funds and what they do is they purchase assets okay and so what I'm saying to you is that this whole discussion of sources and uses of funds for banks like I say we can draw a little picture like this a box and dollars coming in and dollars going on for any financial intermediary and so when we're talking about sources and uses we can relate that discussion of sources and uses back to the balance sheet to this accounting identity now there is a little bit more to the story than that because if we talk about a bank let's say we own a bank we've got a building over here and then there's some equipment inside right well those will be assets that we have as well well we own this building well that's an asset but it doesn't really get back to this idea of sources and uses of funds so there are a few assets that we are not going to be talking about the assets that we are going to be talking about are those that relate to how you know this sources and uses of funds but this all this stuff that and I know most of you have had an accounting class but the stuff that you have learned in accounting it relates back to the nature of the banking business by the way let me also just mention though that when depositors or owners hand money over the bank at that instant before they do anything else they have some assets if they have somebody hands over cash here's $100 that banker has assets at that moment and so now it is a matter of taking those assets those cash assets and turn it into some other asset that earns interest but anyway it's the management of those assets that has to do with the uses of funds so anyway we want to talk about these particular issues let's talk first about the sources of funds and I'm gonna talk about four different sources of funds I'm sorry not for we're going to talk about three different sources of funds deposits borrowing and in capital from owners first of all let's draw off a transaction deposits people put money in the bank the banker receives those dollars now the question is this basically what is the understanding between the depositor and the banker and not only the understanding of how long am I gonna leave the money there but also under what terms and conditions can I add this money back and so with transaction deposits basically what happens is you hand the money over to the bank there is no particular maturity date on those dollars because you're gonna use these dollars for transaction purposes and that means whenever you want to go out and buy something okay could be five minutes from now it could be five years from now so there's no particular maturity date and for you to use these in transactions you've got to be able to roam around the countryside now where you've got to get back to the bank but usually a checkbook or a debit card something of that nature and so the two types of transaction deposits we've talked about before or demand deposits and now accounts and that term now account is an acronym but now is negotiable order of withdrawal holy mackerel that's exactly what your book says what a surprise anyway so we put the money in the bank there is no particular maturity date on it just believe it as long as you want or take it out as quickly as you want and you can use this in transactions like I say by having a cheque or by a debit card or the debit card can typically be used as an ATM card you know and go overseas or in your hometown or anyplace else you want to go and use a card and gain access to your money in the middle of the night or whatever okay demand deposits are the original checking accounts at banks and there is a law called regulation queue I shouldn't say a law that a regulation and this regulation queue says the interest rate on these demand deposits is 0% the Federal Reserve regulates banks and it's got a regulation called regulation queue that sets maximum interest rates maximum interest rates not a minimum and it says you you bankers may not pay more than 0% that's a maximum right but it's very low it used to be we don't have these anymore but used to be regulation queue set maximum interest rates on nearly all accounts that banks deposit accounts so on checking accounts 0% and there never be a small savings account 4% a savings account with three month maturity four and a half percent with a six month maturity 5% and so forth and virtually any type of account you or I would have at a bank regulation queue would set the maximum interest rate why to prevent banks from competing which is kind of a funny idea right now but I told you about glass-steagall and how there were these ideas that came out of the Great Depression people sort of would make up their own story Doppler caused the depression one of the things they said was this let's say you're a saver here and you've got some money and then here are some banks and the banks are saying hey why don't you let us hold your deposit and you say hmm maybe so and the banker says I'll tell you what I'll pay you two percent interest rate on your deposit and then in theory this is all nonsense of course but this is the story in theory this banker would say hey I'll give you two and a half percent and this one say no no give it to me I'll pay you three percent and then round and run it we'll go for four and a half five five and a half six seven eight nine ten fifteen twenty thirty until finally they had bid up the cost of funds so high that they went out of business and so it's this competative competition competition between banks and competition between would be competition competition between banks would drive up the cost of funds that's the theory and the cost of funds would be so high the banks would fail and we've got to stop that from happening you remember a while ago I had this net interest margin up here and I had like what seven percent and three percent and then we've got this net interest margin of four well the theory would be oh this rate would be competed up so high to four to five and so forth until the banks are out of business there is no net interest margin now the economics of this are terrible because if you're running this bank and you said hey I'll pay you three percent on your account and then some other bank said three and a half percent then your bank would just go okay we passed I mean we don't see gas stations stand out there and just bid up the wholesale price of gasoline until they go broke what they say is you know that's all I can afford to buy it whatever $3 a gallon pass you want three-and-a-half know any other company you like if there's a restaurant and somebody shows up and says hey I'll say your potatoes $50 a panel and you say no thanks but the theory is these bankers were just so I don't know addle-minded so unable to manage their business they would compete up the price of funds trying to get these deposits and put themselves out of business and so then the idea is well then we can't have that mmm this is a kind of stuff that happened that led to the Great Depression we can't have that so what we'll do is we'll just keep these banks from competing and set a maximum interest rate none of you can pay more than two percent or three or whatever number the number would change over time gradually not very often but we're gonna set a maximum interest rate and that will present and prevent the banks from competing for deposits pretty much all deposits so what the bankers do then they said well and I used to here but let's make it four if we can't pay more than f
ur percent I still want that deposit and I can't say four and a half pardon a crock-pot or a toaster a clock radio or you know a pet turtle or whatever it is that would cause you to bring that in TV said if you bring in a hundred thousand dollars you know this kind of stuff so they still competed just not with interest and so this was just a totally ridiculous idea okay it was ridiculous on its face but that's where we got regulation cube by the way I'll tell you who liked it the bankers like that right they liked saying that this guy I'm sorry the law will not let me pay you anymore and then all the other banks are saying yeah we can't pay more either and so then this is the bankers are happy because the savers aren't getting a higher interest rate at first at least eventually they turn to the crock pots and toasters and so forth yes sir regulation Q still exists but it's sort of like that glass-steagall where it still exists but we've gone through and crossed out lines of it and so regulation Q is there and could always then be brought back but right now it only regulates the interest rate on one particular account and that is a demand deposit oh that is a demand deposit okay no your demand deposit does not pay interest your now account pays interest see you're just jumping ahead so what happened was this back in the early 1980s bankers just said hey you know we've got this big problem we always like this before where we could not pay higher and higher interest rates and compete for funds but the problem is this back in the 1930s when regulation queue was created that was pretty much it just banks and they said whoa let's don't compete and so they went to their regulator and I said well we support regulation Q but then what had happened by the 1970s and 1980s there a lot of other types of financial institutions out here unregulated financial institutions like mutual funds and the mutual funds were saying this was a period of high inflation you remember we had that nominal interest rate equals the real interest rate plus the expected inflation rate I'll just put a P therefore expected unfortunately well in the 1970s on early 80s there was a lot of inflation this was high and that being the case interest rates were high and so what happened in 1980 was mutual funds were saying hey if you'll give us your money we'll pay you twelve percent fifteen percent and a Fang if the mutual funds are paying twelve or fifteen percent then people take their money out of a bank account and put it in a mutual fund and then the bankers are going man this is not fun anymore people are taking their money away from us and give them to somebody else and then they went to the regulator said please please please get rid of regulation q and the Federal Reserve said no okay we'll get around and do that soon and then the Congress passed the law and they said basically to the Federal Reserve we want you to come up with some new kinds of accounts that are not subject to regulation q interest ceilings and so anyway in the early 1980s is when this was all phased out okay to laws by the way on now it counts and then we're going to talk about non transaction accounts in 1980 and then 1982 we got two different sets of laws passed and what they did is phased out in these regulation queue interest rate ceilings or maximums on all accounts except demand deposits you want to know what these laws were well you already know about this one does anybody remember Garn saint-germain I told you about it earlier I said that it was garden saint-germain made it possible for a bank to take over a failing bank in another state and cross state borders now law also was part of this whole phasing out of regulation queue on all accounts other than demand deposits and then in 1980 see if you can keep up with this di d MC a the depository institutions deregulation and monetary Control Act of 1980 say that three times fast you don't really need to know this but I'll say it again depository institution deregulation and monetary Control Act of 1980 so those two laws were responsible for phasing out regulation q the first one said to the Federal Reserve phase it out over a six year period and then two years later the federal then a Federal Reserve said okay phase-out regulation q over a six year period you know six years from now that's the deadline it's all gonna be done this okay and so two years later the Congress came back and said you haven't done anything in two years and the Federal Reserve said you gave us six years and they said okay well we're not anymore do something this year so anyway one of the things that happened in 1982 was we got now accounts you said that you had a checking account that pays interest what's the pay like about 1/8 of a percent that's pretty good I'm gonna have to switch some money over the bank you do business in anyway so I now account basically what happened was this it was hey we need to have a checking account that pays interest but there still are demand deposits what are we gonna call this and then they tried to come up with a name we can't call it demand deposit because the man deposits pay no interest so this negotiable order withdraw it's an order of a draw that's like a check and the negotiable part is you can go out and present it to somebody in the marketplace and get something for it get cash for it or whatever so anyway this was just kind of a made-up name it pays interest and I'll say interest rate greater than or 0% greater and greater than or equal to but greater than typically usually pretty little rates it's up to the banker within broad ranges in theory yeah well no not in theory the law says this business checking accounts are demand deposits business checking accounts are demand deposits and then personal checking accounts can be either and usually what the banker says is this we want you to maintain a certain balance maybe a thousand bucks but it varies from bank to bank we want you to maintain a certain balance and then we will pay you interest and if you're gonna have a small balance account no interest that's usually the way it works but for a person that's totally between you and banker they can charge whatever fees they want or have whatever conditions they want you can say no thanks or I'll take the deal I don't want spend too much time with this but business checking accounts I said must be demand deposits the only thing is that is almost meaningless for this reason let's say you have a business and you go to your banker you say hey I want to open a checking account not I personally but the business we want to open a checking account they say ok demand deposit and then they say 0% interest you say that's not very friendly and then they say that's what the law is and then you say I didn't ask what the law was I said that's not very friendly and then the banker says I got an idea for you we'll take your money let's say we'll take your hundred thousand dollars or a million dollars or whatever I won't put it in that checking account and then just one minute before we close the doors today we're gonna take all your money out of that checking account and buy a bond for you and you say what's the purpose and they say well you're gonna hold that bond overnight and or an interest on it and then in the morning one minute after we open our doors we're gonna basically buy that bond back from you and put the money in your checking account and so you'll have it available for writing checks but you'll be earning interest do they call this a repurchase agreement and this is a loophole for getting around regulation q yes sir how much do you have to have for them to do that that's between you and your banker I mean you know a banker might just say I can do that for you and maybe you have a thousand dollars in your account but they might say we're not gonna and by the way if I were your background saying a thousand bucks are you kidding me and so then there'd be some minimum but the point is it partly depends not just on that but also the rest of your relationship like if you are a business and you've just got a thousand dollars in your checking account that's small but they might still give you that service because it might be that you're borrowing money from them and paying them a million dollars in interest a year and so they care about the overall relationship and making you feel good about them but if we were just talking about a tiny little account you'd say I don't care yes sir it's a repurchase agreement basically what they do is this is that the end of the business day they sell you a bond and then the next morning they repurchase it so this is a repurchase agreement and like I say it allows the bank or to comply with the law but it also allows the banker to pay interest and so but the banker really is a pain interest really you're earning that on that security so anyway here are our transactions accounts both of these the balances are included in m1 you remember our m1 money supply and here's half of the m1 money supply is the man deposit balances and now account balances at banks and we're talking of around what seven hundred billion dollars that's a rounded off figure but around seven hundred billion dollars okay questions about any of this now the other kind of account or deposit I should say in a bank deposits in banks are non transaction and let me just list a few of these and we don't want to spend too much time with them but passbook savings passbook savings accounts are what most people had as their first savings account at a bank in the old days you actually you know before the computers on stuff you actually got a small little book called the passbook and you take that in and give them you know $2.00 deposit or whatever and then they would take this little book from you and enter that in $2.00 deposit on whatever the date was and then they did initial that and you could take this home and you know get it out and study it and sleep with it and stuff like this and have little dreams about what you're gonna do with your forty seven dollars when you build up to that balance and then as time gone by sometimes we'll hear these referred to as a statement savings account rather than passbook because the idea is now you just get a statement in the mail okay but in any case these do not have a particular maturity date you put the money in the account there's no checkbook and there's no no you know like you just cannot go out and remote locations and buy stuff with this money this isn't a savings account you can go back at the bank and get your money but it is not a transaction account okay there are M MDA equal money market deposit accounts with a money market deposit account it is essentially the same as a state as a passbook savings account there's no maturity date not a particularly high interest rate and you have limited checking privileges just a certain number of transactions within a month I think the number of six and that being the case there's not enough checking account privileges for you this to be a normal demand deposit now account kind of a deal okay but if you need some money you could write a check at some remote location and then savings and time deposits let me take out the savings I'll just say time deposits and CDs and these are accounts that have a maturity date anyplace from and this is negotiable what these maturity dates are it may not feel like it to you if you walk into the bank you've got a thousand bucks and they've got something up on the wall you might think it's not negotiable but you can ask to see a banker and say I want to leave this money for five days I'm all even for five years but anyway there's no general rule but there is a maturity date on this we'll talk more about this next time and here's why I will talk about it some more this is in the trillions of dollars this is huge the time deposits and CDs okay see you next time so long
