August 12, 2012

In addition to my series on predictability and probability, today I would like to announce a new series on Banking. Mainly, I would like to, preferably weekly, outline a fundamental concept on how a fairly large bank works, how it generates its profits and how to check its performance. I will go through all the familiar concepts and even go deep into the details on particular fundamentals and finally I will extrapolate those notions to form an argument against risk assessment and prediction. I will start with the basics, so the more advanced students amongst us will have to do away with patience.

The oldest known bank is believed to be Monte dei Pashi di Siena in Siena, Italy, which has been in operation since 1472. Our bank is fairly old too, going back to 1819. It was founded by a pastor to be based on the English model whose primary purpose was to accept savings deposits. It was a typical scenario throughout Europe, where a public initiative begun and a socially conscious individual emerged and committed the necessary infrastructure for the foundation of a savings bank.

Theses typical savings banks nowadays have emerged to focus primarily on retail business which is a type of banking that deals solely and directly with consumers rather than corporations, sovereigns and/or other banks. We call retail banking our core business. However, we are starting to increasingly deal with other entities including executing complex trades and selling packaged financial assets to contribute to the bottom line. There are many types of banks, i.e credit unions, building societies ect. But Japan has the most radically different banks compared to western banks.

So a typical bank that you and I know operates under a regulated system called fractional reserve banking where they hold only a small reserve of funds deposited and lend the rest for profit. These profits come in the form of mainly interest income on these loans but may also include transaction fees and financial advices minus the interest that the bank gives on those who deposited their money in the bank. The difference in interest charged by the bank on the loans that it issues to entities minus the interest on the deposits is called the spread or a margin – depending on who you talk to. The deposits in a bank is essentially a cost to the bank and the bank must charge a higher interest on loans in order to cover those costs.

So let’s go back to this co called fractional reserve system. This is the form of banking which most banks go about their business. It dictates that a bank only hold a fraction of a customer’s deposit as reserve and the rest is lent out. This creates in the end a ratio which nowadays is used by regulators to gauge a banks preparedness in case of a financial crisis or the bank runs into trouble through having a shortage of cash when depositors demand their money.

The ratio right now for our bank is about 10.4%. That means all the capital that the bank has – that is either deposited at the central bank or not – 10% of which is held to act as buffer to satisfied depositors. A simplified example is, let’s say the bank has € 1,000 from its depositors as its initial money supply, € 900 can thus be lent out to customers. This reserve ratio can effectively turn this € 1,000 into € 9,954 through 50 consecutive loans. This what is meant when you read banks create money out of thin air. We will look closer into that later.

So like any other organization, the bank has on its balance sheet, the assets (loans & other holdings), the liabilities ( deposits and other holdings) and its equity. However, not all assets are loans or risky assets. Only the risky assets counts towards the legal minimum for the fractional reserve ratio. These assets are called Risk Weighted Assets and next week we will look deeper into those and find out how an asset is funded and priced.