JKH summarizes the business of banking

JKH May 14, 2012 at 3:59 pm


Banks compete on price and service.


They compete in asset businesses (lending and investing) and funding businesses (deposits and capital).


They measure gross profit as an interest rate spread in all cases – asset and deposit businesses, plus the margin effect of capital allocation.


They lend at a spread over a benchmark wholesale funding cost.
They raise deposits at a spread below the same benchmark as an interest rate paid.
That benchmark yield curve “splits” the spread between external lending rates and external funding rates.


Surplus funding will show up as surplus reserves. That money can be invested at near risk free rates requiring no capital allocation and no required profit, essentially.


Or it can be used to pay down a money market liability. Either way, the spread earned by the deposit business remains intact.


And if the bank becomes “swamped” with excess funds that it decides it can no longer use without experiencing dysfunction in its money market operations, it can always adjust deposit rates down to turn off the “tap”.


The process works in reverse for loans. The fact that “loans create deposits” is no guarantee the bank will be able to retain the deposits it requires in order to keep its balance sheet “in balance”.


It’s about pricing.


The reserve account at the central bank is an indicator of how much the balance sheet is in or out of balance otherwise. Banks do not want to experience chronic surplus or deficit reserve positions.


(The post 2008 environment is exceptional. Banks must allow for the fact that the system is chronically surplus in reserves. They must have well thought out strategies with a view toward their appropriate or natural or neutral share of such reserves, which are essentially stuck in the system.)


So all asset and funding businesses have their own cost of funds used or return on funds supplied. They are independent to that degree. If there is a business unit that has a mandate to invest in equities, it will pursue that mandate based on its internally assigned cost of funds, without much reference to the actual current experience of the bank in raising deposits at the time.


Banks have centralized risk management committees and asset-liability committees that bring together the disparate business perspectives of all the different business units, in order to track down potential dysfunction risks at the bank-wide portfolio management level. That includes tracking the overall funding profile and any trending liquidity position as reflected in the money market operation.



JKH May 14, 2012 at 4:01 pm


P.S.
I think the phrase “lending deposits” is not a good one.


The balance sheet objective, simplified, is:


Assets = Liabilities + Capital


Deposits are part of the equation that keeps the balance sheet in balance.


That is fundamental to the business of banking.


Reserves are a reflection of imbalance, very roughly speaking – a mirror image of it.


The monetary authority does not expect chronic imbalance, particularly on the reserve borrowing side.


(Again, post 2008 is very special, with chronic system excess reserves.)


So banks use deposits in large part to match assets in nominal terms.
But they don’t “lend” deposits.


They take money on deposit, and they lend money to borrowers.


The net interbank payment effect shows up as reserves.


Think of bond lending as an analogous counterexample. Banks don’t lend their own deposits the way they can lend bonds issued by others.



[emphasis added]

Reposted from the comments at Modern Monetary Realism, Monetarism Unplugged, by JKH.