How Banks Work

I do not think that most people really understand how banks work. That includes me.

Oh sure, we understand that when we make a deposit our money is now in the bank. But what we do not understand, I mean really understand, is that it is no longer our money. We have exchanged the money for electronic promises to pay. If things go badly for the bank, we as depositors are creditors of the bank. We stand in line with all the other creditors. In fact we stand behind most of the creditors.

We feel safe because the FDIC, the Federal Depository Insurance Corporation, promises that if things get dicey at our bank the reserves of the FDIC will bail the depositor out up to $250,000. But the reserves of the FDIC are 1.35% of the insured amount. In normal times this is adequate. Not every bank will go broke at once. I am sure that whatever money that is needed to insure the deposits will be provided, even if this means printing it.

At least I used to think that.

ATMs still work, for now. The crisis in Cyprus did not work out that way. The government of Cyprus does not have the money to guarantee €100,000 per account. Thus the country’s banks must be bailed out by an outside force, but there are strings. Each depositor will lose about 6% of "their" money, any money over €100,000 at the bank will lose 10%. (My guess is that these numbers might change.)  There is a technical name for this. It is called a whoopsie.

Although all sorts of hyperbolic analogies are being drawn to the US, this really does apply. The US will print whatever money it needs to insure the banks do not fold. I used to be 100% sure of this, now I am only 97% sure.

Banker Tweetie says, "I've Been Sick."No, the Cyprus situation is not the dead canary in the mine I talked about in a previous blog post—unless you are a depositor in a Cypriot bank. But I do picture Tweety Bird saying, "I've been sick."

The risk to the banking system is why on a recent post on pre-investments I suggested that one put some money in the bank, and have some at home. While there could be a riot from a bank closure that also burned down your home, this is not likely—you can't hedge everything.

Remember that once the money is in the bank, it is now the bank's money.  I doubt that things will get bad enough that this money would ever be lost, but it might be delayed in returning to you in a crisis. If things get that bad, the money won't buy anything anyway—you can't hedge everything.

Do not be surprised like this one depositor at a Cypriot Bank was.

Do we really understand how banking works? In our head we do. But in our hearts we do not. Reviewing how Fractional Reserve Banking works might be a helpful reminder.

Comments

[Doug Young]

My Dad's dad was quite well off at one time. He was part owner of a bank in little McBain, Michigan. But when things went south in the early 30s and the bank became insolvent, the bank owners were responsible to pay off the depositors ("creditors", as you say) with their own personal assets. This, of course, ruined our family, and they eked out a living off the land until my grandfather died a few years later.