“What is a bank” asked my granddaughter to her dad. “Ask grandpa, he worked for the bank” replied her dad.
I explained: “Well, a bank is where you deposit your money. You see, in the past people hid their money under the mattress. This is unsafe because thieves can steal the money, or fire can burn down your house and money. So, it is more secure to place your money with a bank”. This explanation is good enough for an eight-year old but of course there is more to it. It is perhaps still a mystery to many people as to how a bank really operates.
Lending money has a long history. You will remember Shakespeare’s Merchant of Venice, whence Shylock demanded a pound of flesh when Antonia could not repay a loan. This is exactly what a bank does today, the lending of money, to be repaid afterwards with interest.
A bank can only lend out a limited amount of money out of its own capital. So, it needs to gather deposits from the public which it may then lend. The more the deposits the more it can lend out. To put it in perspective, in 2020 HSBC has an equity (capital) of 192 billion US Dollars while it lends 2.715 trillion. Deposits are therefore very important to the banks, and that’s why banks compete vigorously for deposits by offering attractive interest rate.
There are different options as to how you can park your money with the bank.
The most basic is the “Savings Account”. You get a passbook, though nowadays you get a statement instead, which records the money you put in as well as the money you take out. In the 1960s HSBC in Hong Kong encouraged children to save by providing widely its own iconic “piggy bank”. Children were excited to watch their passbook balance built up and earning monthly interest in the process. If you have large amount of money, you can park them in a Term Deposit Account which offers higher interest rate. Term deposit ranges from minimum 7 days to 5 years. During that period, you cannot withdraw the money, unless you pay a penalty.
Next you can park your money in a Checking Account. I think Checking Account is a marvel financial instrument. Imagine you have to carry large amount of bank notes to pay for something you want to purchase. We can go further in time, when in China gold had to be physically moved from one place to another for payment of goods, the convoy guarded by Kung Fu masters from bandits. Payment by cheque has now lost its luster, substituted mainly by on-line electronic payment. I have not touched my cheque book for the last ten years.
It is interesting to note the impact between keeping your money under your mattress and depositing it in a bank. Money kept under the mattress is dead money, it does nothing to the economy of the country. However, money deposited in the bank creates economic activity because the money is lent out to other people who can use it to do more business. In fact, one hundred dollars of deposit can increase automatically threefold and becomes three hundred eighty dollars. It works like this. Customer A deposits $100.00 in the bank. The bank can lend 75% of this deposit to B, equal to $75.00. B has now $75.00 in the bank. The bank can now lend 75% of $75.00 to C, equal to $56.00. It keeps on going until the total money increased to about $380.00. All started because of the first $100.00.
Where does the bank make its profit? It is the difference between the interest it receives from its borrowers and the interest it pays to its depositors. Of course, competition among the banks will dictate how much interest a bank pays its depositors and how much it charges its borrowers. Bank also derives income from service charges and other fees.
It is interesting to note that there is time when depositors, not only do not receive any interest on their deposits but have to pay the bank interest on their deposits. This is when there is so much money on the market which the bank is unable to lend out.
Is it absolutely safe to keep your money in the bank? Not necessarily. Because the bank may not be able to recover the money it lends to the borrower. When too many people cannot repay the bank, the bank in turn cannot repay your money. When people hear the bank cannot repay your money, they in turn rush to try to withdraw their money from the bank. This is called a bank run and it often leads to the bank going bankrupt. In 1965 Hang Seng Bank in Hong Kong faced a bank run but was rescued from bankruptcy by HSBC acquiring a 51% interest in Hang Seng Bank. You may also remember the collapse of Barings Bank, one of the oldest merchant banks established in 1762, when a 28 year old employee lost 1.6 billion Pounds in unauthorized trades.
There is relief to small depositors though. In many countries, customer deposits are guaranteed by the Government up to a certain limit. For example, in Canada, the Canadian Deposit Insurance Corporation (CDIC), which is a Crown Corporation, guarantees the deposit of each customer up to C$100,000.00 per bank, if that bank is a member of CDIC. If you have C$200,000.00, you may place C$100,000.00 with Bank A and the other C$100,000.00 with Bank B, you are then fully covered. If you place C$200,000.00 with Bank A, only C$100,000.00 is guaranteed, the other C$100,000.00 may be at risk.