When I was a Senior in college, I encountered my favorite professor. He was this old hippie type that everyone really liked, me included. With all due respect to the economists out there, this guy actually made learning economics fun! And interesting. And in that last year of school where I probably would’ve dreaded my business electives, he taught a course called “Money and Banking.” And it was a blast! And not only that, but this course still helps me today all these years later, and I think you’ll soon see why.
His course offered a great bird’s eye view of the monetary system in the United States and the history of banking in general. This is actually a topic I try to devote a portion of a chapter to in my new book when I talk about how banking really works. What fascinated me at the time—and even now—was how man went from a trading role of bartering in our society all the way to our current system that we use today.
Many things led us to this point, but what stuck out to me was that the majority of reasons boiled down to two things: safety of your money and ease-of-use. These days, most of us feel pretty safe with our money in the bank. After all, it’s usually insured by the FDIC (thanks to the Great Depression), and as for “ease of use,” I think that’s debatable. Sure, by today’s standards, access seems quicker with new technology, but in places like the U.K., money tends to clear much faster than it does here in the U.S.
Either way, the bank definitely acts like we can come get our money whenever we want; just, of course, bear in mind that’s subject to hours of operation, how many business days are permitted for your transaction, etc. This apparent ease and safety is what really attracts money to them, after all. And it’s with this money that they make money, right? Yes and no. Here’s what I mean.
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Net Interest Margin (a.k.a. Using Leverage)
It can be quite difficult to understand how banks really make their money because banks operate very differently from most businesses since most are highly leveraged, with more than $20 in debt for every $1 of equity. Not to mention, banks don’t make any tangible products and they often offer things like checking accounts for free. On top of that, most people have the process of how the bank lends and borrows backwards. A good analogy would be how the government works, which people also confuse how they spend and borrow. People imagine that the government must first collect taxes or borrow money in order to fund budgetary needs and expenses. In reality, the government just spends what it wants and is approved for and then collects taxes in order to balance out the effect the spending has had on the money supply. Isn’t it funny how people think the opposite about both the government and the bank? The important thing to remember is the government spends first and funds later, and banks lend first and fund later.
The way the process works in a nutshell is this: Banks attract depositors by offering to pay interest on funds held in deposit. They then pool their depositors’ funds and lend this capital to qualified borrowers at a higher interest rate. Simple enough. The bank earns money on the spread between the rate of interest it pays out and the rate of interest it charges on loans. This is called the “net interest margin.” Bank regulations require banks to maintain a set level of capital to satisfy those who have their deposits in accounts, so that money can be readily accessed but occasionally a bank may run low on cash and need to borrow short-term funds from the Federal Reserve.
These loans are made at a low interest rate, commonly referred to as the Federal Reserve discount rate. What’s unique about this strategy, called “fractional reserve lending,” is that the bank has lending power on capital they don’t necessarily have in-house. And they borrow it at this low Federal Reserve rate and make a spread. This is also done to expand the economy by freeing up capital that can be loaned out to other parties. This system was also partially implemented because of incidents during the Great Depression where many U.S. banks were forced to shut down because too many people attempted to withdraw assets at the same time.
Interchange (a.k.a. Points)
So, that’s one way banks make money—leveraging both the Federal Reserve’s money as well as borrowers’ and depositors’—but that’s not everything. Everyone thinks the bank is in the lending and saving business with borrowers and depositors, but they’re also in the spending business. Americans spend more than they save; this much we all know. And guess what? The bank knows this too! This is why they got into the credit and debit card business, especially once they implemented revolving balances.
So, every time you swipe a card at a store, the merchant pays a small percentage of the money to the bank that issued the card, called an interchange fee. For credit cards, this is around 1.7%, while for debit cards it is closer to 1.1%. Just imagine how many cards are being swiped at this very moment. Clearly, this is a huge revenue stream for banks.
Fees (a.k.a. Fees!)
Prior to this class, I pretty much thought that the “net interest margin” idea of depositors putting money into the bank, which they in turn would lend out and charge interest, was how they made their money. It wasn’t until I had a better understanding of the Federal Reserve and the centralized banking system that I realized that’s not the only way.
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Take mortgages, for example. Most banks aren’t known to originate or create a residential mortgage and necessarily keep it in its portfolio. Although there are portfolio lenders out there (which is more common with commercial loans), the majority of residential mortgages are packaged and sold off where the originating bank is following the proper guidelines to enable them to do so, in order for them to make their points (1% of the mortgage amount) and any other origination fees, etc. It’s really more about the fees than the interest. The interest is more of a thing for the larger institutional investors like insurance companies and pension funds.
And it’s not just with mortgages either. Banks discovered that to call a product “free” was a great form of marketing (think “free checking”), but then charging small fees on mostly all transactions—ATM fees, overdraft fees, late payment fees, penalty fees, etc. In the U.S. today, the average household ends up paying over $200 annually in just overdraft and bounced check fees alone. A recent statistic by the CFPB states that in 2016 alone, U.S. consumers paid a total of $15 billion in fees for bouncing checks or over-drafting. Along with interchange, these fees add up to more than 50% of revenue for large banks. So not sure how to put this other than—THEY’RE CHARGING YOU FEES TO USE YOUR OWN MONEY!
Be Like the Bank
So, the real question is, how can we be more like the bank? Well, we could start by acting like one. Keep your money moving in different investment vehicles (aside from reserves; don’t just let it sit there), use leverage to acquire assets, and charge fees and points when lending. And as you’ll read in my new book, the ways of being the bank don’t stop there. The possibilities are really limitless, especially when you start synergistically using notes and hard real estate.
So, as real estate investors, we shouldn’t try to “beat” the bank. Not only is it futile, but they’re not even the enemy. In fact, many times, it’s the bank that enables us to make money. They give us the money to acquire our deals, do new construction, or even provide the permanent financing to take out our hard money or private money lenders. Without the banks’ money, it would have been very difficult to grow my portfolio to its current size, enabling me to provide more rentals to the greater public, and eventually own more real estate long-term. And let’s not forget: Whether directly or indirectly, they also provide us with notes! So I say, when you can’t beat them, join them!
My best advice to any investor is to be more like the bank rather than only being the borrower. So how are you like the bank?