A common answer that comes up first is that banks attract deposits, give loans and earn money from them. It is partially so, but then, why do banks offer different interest rates, which are radically different in different countries?
Since recently, there has been a common practice when a depositor pays a fee to a bank for a keeping deposit, and the borrower receives compensation from the bank, rather than repays an interest on the debt.
How could it be? You will learn from the article about the role of banks and bank deposits in the whole macroeconomic system, why banks need money in general, and what the negative interest rate is.
The answer seems obvious: banks attract deposits, make loans and gain money from the difference between loan rates and deposit rates. Usual funds distribution in the economic environment. However, everything is not that simple. For example, have you noticed that in some countries deposit rates are higher than loan rates?
Yes, it is about deposits for individuals and targeted loans for legal entities. But still, a fact takes place. And in some countries the situation is even more interesting, deposit interest rates are negative! That is, those who invest money in deposits now also have to pay for keeping them in the bank. But the borrowers are satisfied.
For example, in Denmark, banks also pay a premium to mortgage borrowers (the interest for the use of the loan is not charged). It seems incredible, doesn’t it? In fact, everything is quite reasonable.
Banks and people: circulation of money
Banks play the part of an intermediary in the financial services market. Simply put, they accumulate money from some sources and redistribute it to other sources.
Sources of money for the bank are deposits of legal entities and individuals, income from cash and settlement operations (transaction services), investments in various types of assets, including securities, income from lending to individuals and legal entities, and other banks.
Banks can redistribute the money in loans, investments (purchase of securities, derivatives), deposits in other banks, including central banks, etc.
1. Intermediary in the money cycle
Everything is simple here: the bank attracts the money of those who have spare funds, pays the premium in the form of interest, and distributes it to those areas that generate its profit, covering the costs of deposit servicing.
One could say that banks thereby stimulate the development of the national economy, supporting loans and investment companies. But everything serves a single purpose – make profits.
The deposit interest rate depends in a way on how much a bank wants to get the depositor’s money. And the key factor is its strategy. For example, as experience proves, the loan interest rates are higher for retail short-term collateral-free loans (this is because of their higher risk level).
Accordingly, a bank aimed at retail lending will offer higher deposit rates. If the bank has an appropriate risk management system, then the probability of losing the deposit will be insignificant.
Why does the bank need the depositor's money? To make loans. But there can be a different situation: to cover the holes in the balance sheet. I’ll give an example from real life. In one country, there was a mortgage boom at some point.
It was more profitable to take real estate loans in foreign currency due to lower interest rates in the equivalent, and the loans, of course, were long-term.
Therefore, those who took loans in foreign currency were completely surprised when their loans increased by three times after the local currency’s value was set free.
There started mass payment failures and challenging credit contracts. Banks had to cover the foreign exchange difference from their own income reserves. Attempts to sell the mortgaged property, estimated at the previous exchange rate, did not solve the problem.
As a last resort, banks raised deposit interest rates, hoping to solve the liquidity problem at the expense of investors. However, the investors themselves subject to panic quickly withdrew their deposits. The outcome was logical: about 1/3 of the banks that could not close the balance gap was closed.
Something like this was in the USA in 2008. At that time the bank needed the money of depositors and investors to fund new mortgage loans.
They issued mortgage-backed securities (a type of security), which were said to be funded by the loans, and sold them to investors. Conclusion: high-interest rates on deposits may suggest potential problems for the bank.
There is another remarkable moment. If a bank offers a high deposit interest rate it doesn’t always mean that the bank needs your money. It may need exactly you.
Attracting clients, the bank also tries to impose on the other types of services: loans and credit cards, payroll projects, underwriter services, issuing guarantees, selling precious metals, brokerage services, value storage services, etc.
2. Support of their own liquidity
Bank assets are grouped according to the terms. Simply put, the bank needs to maintain instant overdrafts, short-term consumer loans, issue long-term loans, have sufficient cash reserves, etc. Therefore, the bank’s liabilities have a structural division into the time range.
In order to maintain short, middle, and long-term liquidity, the bank may change deposit interest rates. For example, to provide higher interest rates on short-term deposits or, on the contrary, to attract long-term deposits without the right of early withdrawal for long-term loans.
It also should be added that the bank may need money to provide the liquidity coverage ratio and capital adequacy, demanded by the central banks. Sometimes, there may be minor cash gaps, that is, a shortage of money in the short term. They can borrow money on the interbank market or conduct repo transactions. Or they can raise deposit interest rates.
3. Participation in the monetary system
One of the central bank’s functions is to provide the appropriate money supply. Simply put, if at a certain level of production in the country there is a lot of local currency, prices will be higher, if there is little of it, prices will go down.
Too much money – high inflation, too little money - overheating of the economy. Both states set back the economic development of the country. Therefore, advanced economies set the target inflation rate. For example, the target inflation of 2% annually is in the USA and Japan.
While in emerging markets, banks make every effort to attract depositors, in advanced economies, the situation is the opposite. What do the banks in developed countries need our money for? Nothing! They would be eager to abandon deposits, but people themselves are willing to deposit their money, setting their country’s economy back.
As it has been written above, roughly outlined, people deposit their money in banks, banks make loans for development, production, updating, and improvement of technologies and equipment. If people keep their money in the bank, the consumer demand declines (it is logical since people already have everything they need.
Why should they buy one more car if they can keep their money in the bank? Enterprises that do not receive loans reduce production. Insufficient development and upgrading of technologies eventually lead to structural economic problems.
There is another factor. A strong national currency is unprofitable for exporters because their revenue is in a foreign currency, but they buy raw materials and labor for the money of their country. The leading central banks of advanced economies faced both of these problems.
In 2009, the Swiss National Bank for the first time introduces negative interest rates on its sight deposit account balances, thus forcing commercial banks to pay for deposits. “A fee for keeping money” - the same way went commercial banks in relation to individuals.
The goal of the central bank was to make money work by means of the monetary policy tool; it should run in the economy, bringing added value, rather than lay on bank accounts. Continue reading with Litefinance.com...