The Banking Sector: How does it really work?

 

Banks are notoriously tough to value. Regular valuation techniques don’t work on them. How do you estimate cash flows for a business which generates its bread-and-butter from cash itself? The difficulties in valuation are compounded by increasing regulation of the banking sector.

Banks are a vital piece of a nation’s financial stability. They are, what Former Fed Chairman Ben Bernanke calls, ‘systematically important financial institutions’. This causes a bank’s growth, capitalization, and risk appetite to be largely determined by regulators.

I’ll leave the difficult task of valuing banks to a later blog. I’ll also explore the red flags one should look out for when screening companies in the banking sector in the next blog. For now, one must take a step and ask: what do banks really do?

How do banks really work?

A basic lending model consists of savers (depositors) and borrowers (loanees). The bank itself is a borrower too, but in a different sense. It is what we call a ‘financial intermediary’.

The bank borrows from its depositors and lends it out to individuals and organizations at a higher rate than it borrowed from depositors – pocketing the spread between the two. But hang on a minute: why don’t savers lend to borrowers directly? Well, that’s very difficult for several reasons.

Let’s say, a saver has $1,000 in savings. Now to earn an interest on that $1,000, that saver would have to find a borrower that needs exactly $1,000 or close to that. Then, the saver would have to study the borrower’s prospect of repaying the loan and the riskiness of the loan. What happens if the borrower dips? The more you begin to think about this story, the more problems pop up. This is where a bank steps in. It allows savings to be easily directed towards those who need it and are able to return it with interest.

Now, when a bank receives a deposit, it keeps a share of the deposit in its reserves to safeguard itself against deposit withdrawals. But once a loan is made, the borrower keeps the loan in a bank too. Now the loan which was deposited is lent out again after holding a certain portion in reserves. This process continues ad infinitum. It is known as the ‘money multiplier’ process within a fractional reserve banking system.

But since a bank essentially borrows money from its depositors, what is seemingly its asset base (deposits) are actually its liabilities. Meanwhile, the loans a bank makes are its assets. Because the interest spread earned on the loan is where their income lies. This is why a bank’s balance sheet shows deposits as liabilities and loans as assets.

This slight difference in accounting makes banks completely different from usual businesses. A usual business has their cash-generating machinery or plants as assets. But banks have their cash-generating deposits as liabilities.

But what about the difference left between a bank’s assets and liabilities? That difference is known as shareholder’s equity or bank capital. If the bank makes losses, it has to dip into this equity to fund those losses. But if the equity is wiped out, the bank becomes insolvent. However, a bank may collapse even if it is solvent but is unable to match its short-term liabilities with its short-term assets. This is usually the case when a run on the bank takes place or when there is a fire sale of assets.

The bank can also borrow money from other financial institutions allowing it to expand its ability to lend (called non-deposit debt). It can also offer various financial products like investment banking services, credit cards/consumer finance, swaps, futures etc. The purpose of these products is to streamline the flow of savings to borrowers, raise capital for organizations or help businesses and people hedge the risks they face. For example, a futures contract allows a farmer to hedge the risk of falling commodity prices just like how crop insurance helps the farmer hedge the risk of extreme weather.

Financial innovation: A sham?

Although the core business for banks is still lending out the deposits they receive, there have been changes to their business model. Through financial engineering in the recent past, banks have begun to offer more and more financial products.

Famously, Warren Buffett called derivatives the ‘weapons of financial mass destruction’ in Berkshire Hathaway’s annual meeting of 2007. Similarly, people often question whether these new financial products create any value at all for the economy.

I would say Buffett’s point is well-taken that financial products like derivatives are used in an increasingly risky and dangerous manner. But to say that financial innovations do not create value would be a huge injustice.

Take credit default swaps (CDS) as an example. A CDS allows a bank to shift the credit risk of a loan (risk of default on loan) to another creditor willing to take on that risk in return for a premium. This ingenious product allows the bank to reduce the reserves it needs to hold, thus boosting its ability to lend and expand credit. If used responsibly, this would lead to a permanent increase in credit within an economy, delivering greater growth and job creation.

But as we know, CDSs were abused in the run-up to the 2008 financial crisis as the risk of the loans insured by CDSs were neglected by the underwriters or hidden by the loan originators. 

However, that does not mean that financial innovation should be discouraged or that the work banks do doesn't create value. Financial innovation should be encouraged but regulated to minimize undue risk-taking.

The work banks do is important. They hold the most important key in an economy: credit.