Banks Need To Maintain Confidence
People do appreciate the importance of banks being able to deliver on their promises to repay the loans that people make to them under the guise of deposits, and there have been many instances where banks have failed to do so, resulting in bank failures, and without outside protection depositors may end up losing at least part of their deposit.
This is so important to avoid that some governments will offer depositor protection, making good on any losses that result from bank failures, up to a certain amount. For example, the FDIC in the United States insures depositors up to a quarter million dollars if the money is deposited in one of their institutions.
These member institutions contribute a small percentage of their deposits to the FDIC to bankroll the insurance scheme, which gets passed on to depositors in a sense, although the amount here is negligible.
The real risk to banks though isn’t that they will go bankrupt, in other words having their liabilities exceed their assets, it is the risk of a lack of liquidity, not that they cannot meet their obligations overall in time, but that they can’t do so in a timely manner.
Imagine that everyone who had money on deposit at a bank showed up at their doors looking to withdraw it. Banks only have access to a certain percentage of this deposited money at any one time, and the rest is loaned out or tied up in securities. This money will provide future profits for the bank but the principal is tied up in longer term arrangements that isn’t accessible now.
Imagine that there are only two clients of a bank, yourself and another person. You deposit $10,000 at the bank and they then loan $9000 of it to someone, who spends the money and agrees to pay it back over 3 years. They keep $1000 on hand in case you need to get at some of this money.
However, you show up and ask for the whole $10,000. The money isn’t there though, and they can’t just ask the other person to pay up right now, they can afford the monthly payments but they just don’t have the whole thing. The bank can’t just tell you sorry we don’t have it though.
So this is where the central bank comes in, and the central bank is there to mostly preserve people’s confidence in the banking system. Banks are well prepared to repay their obligations to depositors but they still do need a backup plan, a place to borrow money themselves should they need to, a lender of last resort, and while banks often borrow from other banks when needed, loans from the central bank are also available and do help banks balance their books so to speak on a day to day basis to continue to meet their obligations.
When you see quotes and changes on the central bank’s discount rate, this is the rate they charge banks on their loans to them, and this does play a big role in the banking system, which is why central banks raise or lower this rate to affect interest rates overall.
In some countries though, people do lose confidence in the banking system to some degree, as there is a real limit on how much assistance a central bank can provide. We still do see runs on banks from time to time, people lining up to take their money out, which is always a bad thing. So in a real sense, the creditworthiness of banks matters greatly, and we must always seek to preserve this, in all banks, because when people lose confidence in banks this is never a good thing.
There are three different types of deposit accounts that banks generally offer their depositors, which are current accounts, often called checking or chequing accounts, depending on the country and the spelling, savings accounts, and term deposit accounts.
Current accounts generally consist of money that is generally only held for short periods of time, or a large part of the funds in these accounts are temporary deposits, although some people do keep extra in their current accounts, using it as a means of saving as well as transacting.
Transactions account for the majority of money that moves in and out of these accounts though, so banks need to maintain a high reserve ratio with these accounts. This means that they need to have a higher percentage, and a much higher percentage actually, of the money on these accounts available than they would with savings and term deposit accounts.
For instance, your paycheck may go into your current account, and from there, the various expenses that you incur during the pay period would come out of it. So if you spend 75% of your pay during the period, or allocate it to be transferred elsewhere, which includes savings and investments elsewhere, then the bank can’t just lend out all of it or almost all of it, they have to keep a fair bit behind.
So this is one of the big reasons why banks often will charge fees for these accounts, as aside from the additional costs to the bank due to the much higher number of transactions, banks don’t really make that much profit per dollar deposited like they do with other deposit accounts. So they do often want to be compensated for this.
Many people complain about bank fees but they don’t often understand what they are getting back from current accounts, they do get access to their money but doing so does involve costs to the bank and they simply are not able to generate a profit with these accounts alone, so they have to resort to charging fees to do so.
Savings and Term Accounts
With savings accounts, the intention is to keep the money in the bank for longer periods of time, often for significant periods, and with these deposits, banks can much more confidently lend this money out or invest it and not expect that a high percentage of their savings deposits will be requested at any given time.
Some current accounts do pay interest to depositors, as in incentive for them to keep the money in these accounts longer, but most do not, and when interest is paid, it is generally a lesser percentage than what is paid with actual savings accounts.
With savings accounts, the idea is that people often will want to save their money up and banks offer a convenient way for them to do so, without having to transfer the money to a savings account elsewhere, in other words they can maintain their current or transactional account and their savings account at the same place.
Banks not only compete with each other but with other forms of investment, so they offer interest rates which tend to be comparable. Most depositors don’t pay that much attention to rates though, and retail banking is driven much more by relationships than by price, so the fact that a bank down the street may be paying a little higher interest on their savings is something that they probably aren’t even aware of and it wouldn’t matter to them much anyway.
There are some depositors though who are very price sensitive and will shop around for the best rates, as well as taking advantage of various promotions that banks may offer, paying higher interest over a short period as an incentive to gain new deposits.
The deposits with the most stickiness though are term deposits, where depositors agree to keep their money on deposit for a certain amount of time, often involving several years, in exchange for a higher rate. These deposits may or may not be redeemable, and when they are redeemable, depositors are assessed a penalty, often not receiving any interest at all on their money if they take it out early.
With some arrangements, term deposits cannot be withdrawn at all unless one is under severe financial hardship, and these are the most reliable deposits for banks, since they know that only an extremely small percentage of them will ever be redeemed. So they can lend the money eve more confidently in this case.
Banks do know what they are doing though when they take deposits from us and use it for other purposes, and on the face of it this may all seem to be pretty precarious to some people, but today’s banking is very stable and reliable and governments will stand behind them to ensure that the potential for problems is kept to an absolute minimum.
This allows people to deposit their money at banks with a high degree of confidence, which is required for this system to work properly.