Around 1997, while I was
in Japan and the Japanese banks were having a hard time, I decided that I
should gain a better understanding about what was happening with the banks.
In other words, I decided to learn how banks work. This was not that hard --
about an afternoon's worth of reading and head-scratching. Afterwards, it
dawned on me that almost nobody else understood how banks work -- not
politicians, not journalists, not economists, not wonky think-tank types.
Indeed, hardly anyone involved with resolving the problem with banks had any
idea how they worked.
Do you think this may
have led to a failure to Identify the Problem? You bet it did.
Way back when (October
2002), I wrote a little thingy for the Financial Times which involves the
themes of Identifying the Problem and How Banks Work. Here's the link:
http://www.colorado.edu/econ/courses/roper/countries/japan/cache/02.10.14-FT-Japans-bank-debt.htm
Apparently, it was later
used in some U-Colorado course.
There are some people who
know how banks work. These include bankers, bankers' accountants, and stock
analysts. Unfortunately, none of these people have much of a mouthpiece, and
also they don't know much about economics for the most part, so they often
have little influence on the policymaking process. Even if the bankers did
try to explain the situation to a policymaker, the policymaker probably would
be completely unable to grasp what they were talking about. (This is one
reason why it's nice to have a real banker as Finance Minister or Treasury
Secretary.) The result is that the policymaker tends to listen to
journalists, the IMF, economists and other such knuckleheads -- people who
don't know diddly about banks, and are therefore largely incapable of
Identifying the Problem -- because he can understand what they are saying,
even if it's a load of crap.
He can understand it
because it's the same as what he's reading in the media, which is where the
journalists quote the IMF, economists, think-tank types etc., producing a
sort of Mirrored Hall of Ignorance.
So, what we are going to
do today is what I did back in 1997 -- namely, take the public financial
statements of an actual real-life bank (we'll use Wells Fargo), and figure
out how the company works. (For the pros who already do this every day, you
might want to spend this week at perezhilton.com instead.)
Download Wells Fargo's 2006 Annual Report By
Clicking on This Link
Ideally, print out the
whole document.
Go to .pdf page 71
(printed page 69). This is the Consolidated Balance Sheet, the most important
page in the whole document.
From this we can
understand Wells Fargo's business. In the Assets section, we find that it
holds $319 billion of loans. It also has $15 billion of cash (really
short-term loans), $6 billion of Fed Funds sold (sort of a short-term loan),
$42 billion of securities available for sale (probably mostly fixed-income
securities, aka bonds, aka loans), and $33 billion of mortgages held for sale
(loans). Aside from some real estate and goodwill, basically Wells Fargo owns
a big pile of loans.
Where did it get the
money that it loaned out? It borrowed it from others. On the Liabilities side
we find: $310 billion of deposits, $13 billion of short-term borrowings (from
other banks probably), some unpaid bills (accrued expenses and other
liabilities) and another $87 billion of long-term debt. So, on the
liabilities side, we see that Wells Fargo also owes a big pile of money to
other people (mostly depositors). Do you see why I say that a bank deposit is
really a loan to a bank? It's right there on the balance sheet, as money that
Wells Fargo owes to you.
The difference between
the assets and the liabilities is the Shareholder's Equity, also known as
book value. Thus, if you own $10 of goodies and have $9 of debt, you have net
equity of $1.
So, a bank makes money by
borrowing money from depositors, and then lending that money out to
borrowers. It makes an interest income from the loaned money (the assets) and
then pays interest on the borrowed money (the liabilities). The difference
between the money received and money paid is profit to the bank, and
ultimately to the shareholders in the bank.
On .pdf page 44 is a
table of interest received and paid on Wells Fargo' loans and borrowings.
We see here that Wells
Fargo gets an average of 7.79% from its loans (that's your mortgage, credit
cards, business loans, etc.), and pays out an average of 2.96% on its
borrowings (that's your savings accounts, checking, CDs etc.), producing a
Net Interest Margin of 4.83%. (That's pretty good!)
This profit shows up in
the income statement, the second most important item in the report. It's on .pdf page 70.
Here we see the interest
received ($32 billion) minus the interest paid ($12 billion) producing net
interest income of $20 billion. Then there is a provision for credit losses.
Afterwards, Wells Fargo declares $17.7 billion of net interest income. Then,
there is is about $16 billion of noninterest income (mostly fees and charges,
and don't we all know about those),
followed by noninterest expenses of $20.7 billion, mostly salaries and other
compensation. At the end of the day, Wells Fargo made $12.7 billion before
taxes, and $8.5 billion after taxes.
Quite a lot of work to
make $8.5 billion, no? They had to carry a ginormous $481 billion dollars of
assets to make that relatively puny $8.5 billion in profit. That's a ratio of
1.77% (return on assets). Which is sort of low, you could say.
However, the shareholders
did pretty well. The total amount of capital invested in the company (crudely
speaking) was $45.9 billion, the shareholders' equity or book value. So, if
you had a $45.9 billion investment and got paid $8.5 billion in profit for
just one year, that's a Return on Equity of 18.5%. Sort of like a bond that
pays 18.5%. Juicy! That's why there are so many banks out there.
You can look at it this
way: You start with $46 billion dollars. You borrow $436 billion dollars and
lend $481 billion dollars (approximately). You make a profit of $8.5 billion
dollars.
Now, nowhere in this
exercise does the bank "create money." It borrows from one entity
(the depositor mostly) and loans to another. It is an intermediary. Nor does
the bank "multiply money." Try asking a banker, "How much
money did you multiply last year?" Huh?
The difference between
the rather mediocre yield on loans (7.79%) and puny return on assets (1.77%)
and the splendid return on equity (18.5%) is due to leverage. We can see that
the bank is levered about 10:1, namely, it carries $481 billion of assets on
a $46 billion capital base. This is sort of like the homeowner with a 10%
downpayment, who carries $500,000 of assets (the house) on a $50,000
downpayment and a $450,000 mortgage. 10:1 leverage is pretty typical for a
bank, and has been determined over time to strike a nice balance between
profitability and resiliency.
Actual computation of
"capital ratios" is rather more complex, and is found on .pdf page
116, "Regulatory and Agency Capital Requirements." Here we find
that the regulatory capital ratio is 12.50%, which is pretty close to our
simple 10:1 (10%) ratio.
We will finish this week
with one more point, namely "bank reserves." Reserves are cash held
by the bank against withdrawals of deposits. We haven't mentioned them, have
we? Reserves are noted on .pdf page 80. "Federal Reserve Board
regulations require that each of our subsidiary banks maintain reserve
balances on deposits with the Federal Reserve Banks. The average required
reserve balance was $1.7 billion in 2006 and $1.4 billion in 2005."
Whoa! Are you telling me that there is only $1.7 billion in reserves (plus a
little vault cash) against $310 billion of deposits?
Waaah! Get my money out
of there!
Actually, this is quite
common today. No bank wants to sit on reserves, which do not earn interest.
They loan out every penny they can, to collect interest income. This is
possible today because of the Federal Reserve, among other things. If a bank
is facing withdrawals, it can get the cash by a) selling something for cash,
b) borrowing from another bank, or c) borrowing from the Federal Reserve (via
repos or the discount window). We won't get into the issue of liquidity
shortage crises here, which were a systemwide shortage of reserves. This
problem doesn't exist anymore, because of the Federal Reserve. To make a long
story short, a bank like Wells Fargo should never have a problem getting the
cash to pay your withdrawal ("should never" anyway). Maybe that
"fractional reserve" stuff is meaningless when there is effectively
no reserve at all? You can see why I
chuckle when people go on about that "fractional reserve" nonsense.
(The $15B of cash and due from banks could be considered a sort of reserve.)
Now that we have an idea
of how banks work in normal times, next week we will look at how banks lose
money.
You should keep poking
around the annual report for more detail about how all the various bits and
pieces work. Spend a couple hours at it, if you can stand it. It's complex,
but reasonably commonsensical (to the extent that any US bank was
commonsensical in 2006!).
* * *
I rented Rollover (1981,
Jane Fonda, Kris Kristofferson, Hume Cronyn. Fonda's company IPC produced.)
from Netflix and watched it yesterday. It is a financial thriller that
fictionalizes the worldwide currency collapse that some people worried about
in the late 1970s and very early 1980s. Just the thing for today's headlines,
if you ask me.
Senior trader at Boro
National Bank: "Gold just went over $2000!"
Head of trading at Boro
National Bank: "It'll be cheap by this evening."
I love it!
Financial thrillers are
pretty hard to get right, compared to car chases, gunfights and
computer-animated aliens, since they largely consist of people on the phone
speaking in tongues. Nevertheless, the characterizations are pretty interesting
and I think this one hits pretty close to the mark. Kris Kristofferson is a
turnaround artist hired to save beleaguered Boro National (think Jamie
Dimon). Jane Fonda is the recently widowed wife of a chemical company mogul,
a high-society trophy (and former movie actress in the film) with ambitions
to assume the management of the chemical business via a Saudi-financed
takeover of a Spanish chemical plant . (Fonda married Ted Turner in 1991.)
Hume Cronyn is the president of a major bank, which is quietly helping the
Saudis move out of paper currencies and into gold.
I heard elsewhere that,
in the last scene, the Hume Cronyn character leaves Midtown by rooftop
helicopter to a well-stocked bunker in the hills while demonstrations erupt
in the streets. However, in this version, he commits suicide. What -- did he
feel guilty or something? Gimme a break.
* * *
Speaking of well-stocked
bunkers: Barton Biggs, the former Morgan Stanley eminence grise turned bigfoot hedge fund manager, has a new
book that reportedly recommends that rich people buy a remote farm or ranch as
insurance against disaster.. Now, where did he get that idea?
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street Journal
Asia, the Japan Times, Pravda, and other publications. He has appeared on
financial television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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