From childhood, we endeavour to teach our children the importance of savings and how to open and operate a bank account. When we get our first salary or earn our first income, we are likely to invest in bank deposits. This is fine for a start; but it is not a good idea to continue for all times. The monsters of inflation and income-taxes will eat up a lot of savings. When we decide to start a business, we look to a bank for financing our business ventures. When the economy seems to be in trouble, we park our hard-earned money in bank accounts little knowing that the banks themselves are bankrupt in the short run, saddled under the burden of large non-performing assets (NPAs). Today, we will proudly and tirelessly use the various modern technological banking facilities like Internet and mobile banking, ATMs, etc.
What is a bank? Simply put, a bank is a money-lending business. But it involves astute liability management, judicious credit appraisal and lending, intelligent treasury operations, appropriate cost set-ups, vigilant risk monitoring, etc. All of this results in good banking experience for customers, timely loans for borrowers, systemic stability for the regulator and enhanced shareholder returns for investors. In the good old days, there used to be barter system—goods and services used to be exchanged for goods and services. However, man created money as a medium of exchange and store of value. Over a period of time, the creator became a slave of his own creation—wage slave of the employer, tax slave of the government and loan slave of the bank. Banking is the riskiest of all businesses because it’s nothing but a sophisticated system-oriented money lending business. Banks work under the ‘fractional reserve system’—they borrow Rs100 as deposit and can multiply it by, say, nine times and lend Rs1,000 in the form of loans. For example, say, there is a bank called XYZ Bank. Now, the owners or shareholders put Rs100 of their own money called share capital. Based on this, the bank is now allowed to accept around Rs900 in deposits (like current and savings accounts, fixed deposits). So, the bank now has total available funds of Rs1,000. Let us assume it invests Rs400 in government securities and bonds which results in its having surplus funds of Rs600 which it then lends. The typical balance sheet of XYZ Bank would look as follows:
To puts things into perspective, XYZ Bank has lent and invested Rs1,000 with its own money (capital) being just a fraction of it at Rs100 and the remaining Rs900 is depositors’ money. Therefore, if we assume that all the depositors of Rs900 simultaneously go to withdraw their money on a particular day, then the Bank just has Rs100 of its own capital to pay them off immediately. Therefore, in the short term, all banks are actually always bankrupt!
Even in the long term, the ability of the Bank to pay off all the depositors of Rs900 depends on whether it is able to collect back the loans from the borrowers or realise the value of its investments.
If even some of the borrowers default, eventually the bank will be forced to default to its depositors. In reality, if such an eventually should arise, the government will, most probably, bail them out. And this bailing out will not happen by any magic wand but either through ‘money printing’ which will result in inflation and the rise in the prices of goods and services in the economy will eat directly into the stomach of the poor or through additional taxes which will further burden the already strained finances of the middle-class. This may sound scary, particularly when almost all people somehow or the other deal with a bank either by way of a borrower, depositor, employee, shareholder, regulator and so on. So what will you look for in a bank?
If You Are a Borrower: The bank should be promoted by a reputed institution or government and be in existence for a reasonable amount of time.
If You Are a Depositor: In addition to the point of the borrower (above), you will also ensure that the bank has adequate capital and has negligible, or low, net NPAs or defaulters.
If You Are an Employee: In addition to the points of the borrower and depositor (above), you will also ensure that the bank has good HR (human resource) policy for its employees.
If You Are a Shareholder: In addition to the points of the borrower, depositor and employee (above), you will also ensure that the stock of the bank is available at below or close to book value, unless it generates a high return on equity for its shareholders which justifies it to quote at a premium to book value.
Hence, the next time you look at a bank don’t just judge it by the number of its branches or ATMs or the amount of technology it uses or the quantum of people following or liking it on social media or the courtesy with which its sales people and relationship managers talk to you. Of course, these are added services which the bank is, nowadays, expected to offer, to improve its quality of service and overall customer experience; but these are just superficial services. Remember, choosing a bank is somewhat analogous to selecting a spouse and, in both cases, we should not look at outward superficial beauty but inner core and soul qualities for enhanced long-term relationship.
Be Your Own Bank
We saw how a bank with just Rs100 of its own capital collects Rs900 from depositors and uses the entire Rs1,000 in lending and investments. Now, assume that the bank pays you 10%pa (per annum) rate of interest on the deposits and lends and invests money at 15%pa, then its spread or income is 5% (15 – 5). It earns Rs150 (15% on Rs1,000 lent and invested) and pays Rs90 (10% on Rs900 deposits) thus pocketing Rs60 (150-90). Hence, it earns a return on equity for its shareholders at 60% (Rs60 of profit / Rs100 of shareholders’ funds). In reality, it is not so straightforward and there are operating expenses and other costs; but the principle is the same.
Yes, with very little capital of its own, a bank borrows money from depositors and lends and invests; thus earning income on that money which is not its own. And the good news is that you can also be your own bank. Confused? Just do what the bank does. Borrow money from the bank at, say, 12%pa and invest it in your business or any other investment yielding, say, 15%pa and pocket the net 3% (15-12). The more money you can borrow and invest in business at higher rate, the more money you can make. Yes, it sounds straight and simple in theory and not easy to apply practically; but it’s not that difficult also. Otherwise, so many large business entities would not have been successfully able to follow this principle for years and ages.
Learn before you earn; protect before it’s taken away; budget before you spend; save before you invest; create cash flows as you invest; leverage before it grows; insure before you risk; live before you die; and create and be your own bank. Remember, if you can be a depositor in a bank or a borrower from a bank or an employee of a bank a shareholder in a bank, then you can surely ‘be your own bank’ as well.