How Does Banking Actually Work? Part 2
In this blog I will be discussing:
· How banks transfer money
· How banks make a profit
· How the banks adhere to liquidity and solvency constrains
So, the hierarchy of money is important because of its implication. Gold can buy you currency and vice versa, currency can buy you credit (sometimes securities, but the value of securities makes it impractical to use currency), credit buys securities. Therefore, corporate banks want to hold as much credit as they can.
What do I mean by credit, in terms of banks?
Credit in banking refers to the deposits of banks in other banks. (This is a complicated process, but I will try to simplify it with a scenario) Let’s assume that I deposit money in Bank A, and you have your money in Bank B. I want to transfer you £10,000, so I go on the banking app, and transfer you the money. This is processed in the banking world by your bank, Bank B, receiving an additional £10,000 worth of credit from Bank A. Hence, on a balance sheet:
Bank A | |
Assets | Liabilities |
+£10,000 | |
Bank B | |
Assets | Liabilities |
+£10,000 | |
Bank A gains £10,000 of debt, Bank B gains £10,000 of credit. With no reserves exchanging hands. This allows the Banks to be able to keep the money to make sure that the bank does not fail and so that the bank can use the credit they have now acquired to purchase securities and make a profit. The credit that Bank B has gained, will then be used in their investment banking/ venture capital/ trading purposes to build their assets. However, for Bank A, there is now an issue since they have now gained £10,000 in liabilities. So, Bank A goes to the “London Interbank Offered Rate (LIBOR)”[1] or goes to the “Reverse Repurchase Agreement (Reverse Repo) market”[2] to settle their sums. Because Bank A has ended in a loss, they can choose to use the Repo market or the LIBOR market. If Bank A has more securities than it would like it would go to the reverse repo market to trade the securities for more cash. If the bank doesn’t have any securities that they would risk in the (reverse) repo market, the bank would enter the LIBOR market where a bank in a surplus would charge interest for any money they borrowed. Bank B would want to go to the repo market to trade their excess £10,000 for securities or would be the lenders in the LIBOR market.
Why is this important?
In a phrase, because of the financial crash of 2008. More specifically, the crash resulted in many changes for commercial banks, for example, the “Volker Rule” was introduced. Where central banks were encouraged to keep a “matched book” this is primarily so that banks do not over-commit to one investment, and so that the banks do not face a liquidity concern.
Since this was an information-dense blog, I will keep it short and summarise it. So, banks prefer to exchange credit instead of reserves. The banks use the credit to trade with and make major profits. The banks which have net liabilities (of credit) enter the LIBOR or Reverse repo market to obtain some assets to counteract the liabilities. And the banks with net assets (of credit) enter the opposite side of the LIBOR market or partake in the repo market. The banks do this to make easy and safe profits and adhere to the Volker rule.
LIBOR is now being gradually less used, yet its replacement the "Secured Overnight Financing Rate (SOFR)" is being used instead, but for our purposes, it is essentially the same thing.
[1] London Interbank Offered Rate (LIBOR)- This is a method exclusively for major banks to set both sides of their balance sheet equal at the end of the day. The banks that end the day in a surplus, lend the excess money at the LIBOR rate to banks that end the day in a deficit. Note: LIBOR is only for short term rates, e.g., overnight up to 12 months.
[2] Reverse Repurchase agreement market (Reverse Repo)- This is essentially a trade of securities for credit, the collateral for the trade is the securities that were given to the other bank. The Repo is just the opposite side of the trade (what the other trader is doing). Note: this is an overnight trade
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