Finance: Banking and Money

How do banks make money?

Banks borrow money from people and pay them annual interest. With that borrowed money, the banks lend it out to people and receive annual interest. That loan interest should be higher than the borrowing interest. So the bank makes money off of the loan interest, and then it pays the lenders their interest and the bank profits from whatever is left. Basically, they make money by using borrowed money (or money that people deposit in their bank) and loaning it out with interest. The banks also pay interest to people that deposited in their bank.

Multiplier Effect Intuition

Banks have a Reserve Requirement. It's usually in percentage. Reserve Requirement is the percentage of deposits that the banks must keep on reserves. For example, Let's say the current reserve requirement is 0.2 or 20%. A businessman starts his own company with employees. He makes profit and pays $1,000 to his employees. His employees will probably put that in a bank or deposit it. So the workers put $1,000 in Bank A. Since the reserve requirement is 20%, Bank A keeps $200 on the side. With the rest of $800, Bank A can lend it out. Another businessman comes along needing a startup capital. It borrows $800 from Bank A and starts a company(Here, $800 has been created in the economy). He hires workers. He pays workers with the $800. The workers will save or do whatever but it will end up being deposited at another bank. Let's say the workers deposit their $800 at Bank B. Bank B puts $160 to the side and loans out $640. Bank B lends the $640 to another businessman that needs startup capital($640 of new money is created in the economy!). The businessman pays workers, workers deposit and the cycle continues. As you can see, throughout the process New Money is being created as banks lend out the money.

Repurchase Agreement in Government.

Banks sometimes do this when they are depleted of reserves to pay back people who are withdrawing their money. If other banks are not willing to lend to Bank A, Bank A can turn to the FED as the lender of last resort. The FED will lend the $100 to Bank A, and the FED will take 100 Bank A's treasuries as a collateral. They will do this in a Repurchase Agreement. Basically it's the same thing except it's worded differently. The FED will BUY 100 treasuries from Bank A for $100. Bank A sells 100 treasuries to the FED for $100. Then they sign a Repurchase Agreement saying that on a certain date, the FED will SELL the treasuries back to Bank A for let's say $110(extra $10 is interest). Bank A will BUY 100 treasuries back from the FED for $110. If Bank A can't pay back $110 back to the FED, OR BUY back 100 treasuries from the FED for $110, then the FED can sell those treasuries so that they get their money.

Discount Rate

Discount Rate is the interest rate the Federal Reserve charges to commercial banks for borrowing from the Federal Reserve. The FED can control the supply of money and thus the short term interest rate of the banks by increasing or decreasing the Discount Rate

Insolvency

When an individual or an entity can no longer meet its financial obligation with its lender or lenders as debts become due. They can't pay back what they borrowed.

Treasuries

IOU's from the Government.

Deposit Insurance

In a case where the Banks go bankrupt or bust, if they have a Deposit Insurance, then the Deposit insurance corporation will insure that the Depositers get their money back. Depositors feel safer if a Bank has a Deposit Insurance because it says even if the Bank goes bust, the Depositors' money is safe because they are insured that they get their money back by the Deposit insurance corporation.

How Open Market Operation by the Fed can affect the Overnight rate that banks charge each other for overnight borrowing.

Let's say Bank A borrows from Bank B with an overnight rate of 9%. The FED's target rate is at 5%. In order to bring down the overnight rate of the banks down to 5%, the FED could print cash, buy treasuries with those cash which would increase the money supply in the bank. That means Bank A have more money in reserves so their demand for borrowing decrease, and Bank B money supply in reserve increase so their supply of money that they get lend increase. That means the overnight rate must come down. So the FED can continue this process until they hit their target rate.

LIBOR

London InterBank Offer Rate It's basically just an average of the interest rates that banks are lending to each other. It's calculated by the British Bank Association

Calculating the Multiplier Effect.

Money Multipler=1/Reserve Requirement. Total Change in Money Supply=(Initial supply of money * Money Multipler) - Initial supply of money.

Fiat Currency

A Currency not backed by any hard asset like Gold or something. It it backed by the people's trust in the US economy

Open Market Operations

A Monetary Policy Tool in which central bank buy and sell bonds to regulate the money supply in the economy. Expansionary policy (Increasing Money Supply): The FED would print more money. Then they would buy Treasuries with that money at the Open Market (The FED might buy the treasuries for higher market price so that the seller would want to sell). Then the sellers of the Treasury would deposit money in the bank which would increase the supply of money. Increase in Money Supply would decrease the short term interest rate. Contractionary policy(Decreasing Money Supply): The FED will sell the Treasuries they bought in the Open Market. The buyers will give the FED money and the FED will give them Treasury. This sucks out the supply of money from the economy, thus increasing the short term interest rate.

Fractional Reserve Banking System

A banking system in which only a fraction of of bank deposits are backed by actual cash-on-hand and are available for withdrawal. This is so that the bank can use the excess reserve to invest or do whatever with it to expand the economy. US currently has this banking system. This system was the reason for the Great Depression where everyone wanted to withdraw their money all at once but the banks only had a fraction of the deposited amount.

Reserve Bank

A central bank where all of the small banks' reserve requirements are pooled into. So if Bank A doesn't have enough reserve to pay people who want to withdraw their money, then the Bank can simply borrow more money from the Reserve Bank's reserve poole. In the US, the Reserve Bank is the Federal Reserve. The Federal Reserve also sets the Reserve Ratio.

Overnight Rate (FED Funds rate)

Overnight Rate is the interest rate that Bank A charges Bank B for borrowing Bank A's money that's in the Federal Reserve.

FDIC

Federal Deposit Insurance Corporation. It's a Deposit insurance corporation backed by the Federal Reserve. If a bank is FDIC insured, it means that even if the Bank goes bankrupt, the Federal Reserve will pay the Depositors their money. This gives Depositors more confidence in the banks. Banks pay little portion of Premium to FDIC. Negatives is that is a Bank is FDIC insured, it gives the Banks and incentive to take on more risk because usually if a Bank is riskier, depositors will want more interest, but if a bank is FDIC insured the bank can pay lesser interest to depositors because they will tell them they are FDIC insured and that even if the bank goes bankrupt because of its risky investments, the depositors are safe. FDIC insured banks will take more dangerous risks.

Target Rate

The target rate is the rate of interest at which the FED wants one bank to lend money to the other bank or banks.

Repurchase Agreement Intuition

This is basically an another way of making Collaterized Lending. For example. I need to borrow $1,000. I go to Jack and say can I borrow $1,000. Jack says sure, but I want to be protected with a collateral in case I don't pay back. I have 1,000 treasuries. Jack buys 1,000 treasuries from me and gives me $1,000. We sign a repurchase agreement saying that I will repurchase the treasuries from Jack at a set future date with additional money(interest). Jack will agree to sell the treasuries back to me at that date. This transaction is identical to if Jack simply lends me $1,000 and takes 1,000 treasuries from me as his collateral, but there is no receipt. It looks sketchy. So, we simply say that Jack BOUGHT the treasuries from me for $1,000. And we sign a repurchase agreement saying that I will BUY back the treasuries for more than the original price Jack bought it for(Interest added). And Jack will agree to SELL me the treasuries at a certain date. In a Repurchase Agreement, we just add the words BUY and SELL so that we don't look sketchy. I buy back the treasuries from Jack at a higher price because basically it's like I paid back my debt along with interest, so I get my collateral back from Jack. And Jack SELLS the treasuries to me at a certain date, basically giving me my collateral back when I pay it back.