by Joe Pimbley, Columnist & Featured Contributor
[message type=”custom” width=”100%” start_color=”#F0F0F0 ” end_color=”#F0F0F0 ” border=”#BBBBBB” color=”#333333″]Editor’s Note: This is the next in a new Series of Articles by Joe, as excerpted from his Book; “Banking on Failure” co-authored by Laurel McDevitt. [/message]
BANKS PROVIDE A LARGE VARIETY of “money services.” What is the typical lay person’s opinion of banking? Most likely the words “big,” “rich,” “complicated,” and “infuriating” would be the words describing the general public’s view. We agree with three of these four adjectives. We’d just cross out “rich” and then add “fragile” and “essential.”
We discuss in this chapter the “money services” that are most relevant to the risk and critical role of banking in the economy. Deposits and payment processing are the core of commercial banking. Loans in numerous forms, investment products, foreign exchange, trading and market making, and investment banking all contribute to this story.
Customer Deposits
Likely the most basic and important function of a bank is to provide a safe holding place for money – a “bank account.” All functional adults choose to use this service. In principle, one might keep all one’s cash in a personal safe, but the only evident reasons to favor this option over a bank account are distrust of available banks or desire to “hide” the amount of one’s cash from bank or government authorities.
What is most fascinating about bank deposit accounts is that they are not what many customers (“depositors”) believe them to be. That is, a depositor’s money does not just sit at the bank until he requests a withdrawal. Banks do continue to offer “s
afe deposit boxes” that are simply untouched physical repositories for jewels, certificates, cash, et cetera. But a bank account is not a similar repository for cash. Rather, the bank treats a customer deposit as a loan (from the customer to the bank).
This distinction of describing a bank deposit as a loan rather than as safe-keeping of customer money is profound but rarely contemplated. If an individual lends money to IBM (International Business Machines Corporation) by buying its bonds or commercial paper, then this person knows she is investing in IBM, bearing the risk of IBM default, and being paid an interest rate appropriate for this default risk.
Does the bank depositor understand that he is similarly investing in the bank? Does this depositor want to be a bank investor? We note here two important differences between the bank deposit and the IBM bond purchase. First, the bank depositor may withdraw his money at any time (for what is known as a “demand deposit” and also known as a “checking account”). The investor who owns an IBM bond – and is therefore a lender to IBM – cannot redeem the bond with IBM on any arbitrary day at original par value. This investor may sell the IBM bond to the market, but the price of the bond in the market may be above or below the par amount.
Hence, the bank depositor’s “loan” to the bank has no true maturity date. The depositor has the option to treat each day as a “maturity date” by requesting all or some of his money on any day. This feature is good for the depositor and a huge weakness for the banking system as later chapters will discuss.
The second difference between a bank deposit loan and the purchase of an IBM bond is that the governments of virtually all major economies guarantee the repayment of deposits within their countries. More specifically, in the United States, the FDIC (Federal Deposit Insurance Corporation) – a government agency – guarantees each deposit to a maximum amount of $250,000 if the underlying bank fails.[1] In the United Kingdom, the FSCS (Financial Services Compensation Scheme) guarantees deposits to a maximum amount of £85,000.[2] As with the daily redemption feature of a (bank demand) deposit, this guarantee feature is good for the depositor. The bank, however, continues to treat the deposit as a loan for which it may use the funds in any manner it desires. That is, the bank does not simply keep the deposited funds in its vault. Future chapters explore the meaning and risk of this bank lending of deposits.
Payment Processing
In addition to placing deposits with a bank, the bank’s payment services for individuals and companies are ubiquitous and incredibly important. Customers use their bank accounts to receive and make payments. While it is conceivable to use cash for all person-to-person payments and to mail cash for the payment of bills and invoices, the role of banks as intermediaries in payments is greatly simplifying. Establishing bank accounts permits consumers to use debit cards and checks for payments in lieu of cash.
In any economy, the payment system between banks and corporate and consumer clients and between banks themselves is a necessary utility. Like the electrical grid or water supply or waste removal or food distribution, the payment system is essential.
For the sake of clarity, we elaborate a bit on what we mean by “the payment system.” When a consumer holds, say, $10,000 in her checking account, she may pay her monthly telephone bill by mailing a check written against this account to the telephone service provider. Or she might call this provider or visit the provider’s website to pay the bill with a debit card. Or the consumer may access an on-line account for her checking account to instruct the bank to send a check or wire transfer to the service provider. All of these possibilities are payments facilitated by the bank with the consumer’s funds on deposit. This consumer can also receive payments into her account by depositing a check she receives by mail or by instructing the payor to send funds directly to her bank account.
This explanation sounds simple. It is simple once one has lived with the procedure for a while. The consumer’s mental picture is that “her money” is sitting at the bank and that she can direct the bank to pay a portion of “her money” elsewhere by writing a check, giving debit card authorization, et cetera. She can also increase “her money” by depositing checks into the account. This mental picture works even though it is not quite accurate. As we explained earlier, the bank does not hold “her money” anywhere. The bank merely records and acknowledges that it has a net debt in the stated amount to the consumer – just as IBM has a debt to repay to each bond investor.
If the bank manages and runs this payment system properly, there is essentially no risk to the bank. In all payments, whether a bank acts as intermediary or not, there is the age-old “delivery versus payment” risk. If person A pays person B for a service to be performed during the next month and then person B fails to perform the service, then person A has lost money. The more common risk is the reverse: a business delivers a product or performs a service first and then gives its customer an invoice for payment within thirty days or so. The customer may fail to pay the invoice. In the financial world, parties to a transaction treat this risk more carefully by deliberate matching, for example, of the (wire) payment of cash versus (electronic) delivery of a bond. In all these cases, the risk of loss accrues to the buyer or seller rather than to the bank facilitating the payment.
The next excerpts for Chapter 3 will discuss “Bank Lending,” “Merchant Banking,” “Foreign Exchange,” “Trading and Market Making” and “Investment Banking”
[1] See, for example, http://www.fdic.gov/deposit/ .
[2] See, for example, http://www.fscs.org.uk/what-we-cover/eligibility-rules/compensation-limits/ .
