What Do Bankers Do?

It seems that very few people fail to understand why the banks are bailed out, yet companies like GM are left to fail. Some people think bankers don’t do anything, they just you fees for holding onto your money. 

At a simplistic level a bank is like a retail store. It does not produce anything, instead it acts as an intermediary. Consolidating and dividing orders so that individual customers can buy a small quantities number of items and factories can sell large batches. But banks are more important than this, because money is the foundation of trade.

If you want to buy a house, you will need to borrow a large sum of money. Do you personally know someone you could borrow from? Most people don’t. The only option is to borrow a small amount from a large number of people. A bank provides a cost effective means of achieving this.

From the depositors standpoint, if there is a 5% chance of losing everything, you will not want to lend a person $1,000. Instead by lending $1 to 1,000 people you spread the risk. The same 5% bad loan risk means that 50 people will default. By charging 7% interest, the 950 people will repay $1,016.50 in total. In effect, the depositor is getting a 1.65% return, with virtually no risk of loss.

In most cases, depositors leave their money short term. On pay-day you salary goes into your account and by the end of the month you have spent it all. However, borrowers want the money long term, eg, a 30 year mortgage. If all depositors withdraw their money at the same time, the bank will run out of money because they cannot demand borrowers repay their loans immediately.

This means banks have to borrow from each other to cover short term changes in deposits. For example, on pay day there will be a large flow of funds from your employers bank to your bank. A struggling bank will borrowing money from others banks. If it then goes bust the others have to write off these interbank loans and then they become struggling. This domino effect is the systemic risk people talk about.

To prevent runs on banks, most governments guarantee bank deposits to maintain confidence. Then to prevent the moral hazard of this guarantee casing risky lending, banks have to be regulated. So if you let the banks go bust, the government will end up having to pay billions anyway. At least with an equity injection the government is likely to get its money back, or even make a profit.