How Does A Bank Work?

In light of the recent Silicon Valley Bank (SVB) and other bank failures, let’s take a closer look at how banks operate. We’ll ask two questions: Who are a bank’s true customers? What led to the failure?

See, banks are businesses and like all businesses they exist to make profit. This profit primarily comes from the interest rates that they charge on the loans that they give out. A bank’s main product is money and they sell it to people who need it.

Now to give out loans, a bank needs a constant supply of money. A good amount of this comes from depositors like you and me. In this situation, the bank pays us an interest rate on our deposit for leaving our money with them. This interest is basically the cost of ‘raw materials’ for them.

If we distil this further, we can see that the true customers are those who borrow from the bank. They’re buying the bank’s product (money) and paying a cost (interest). Depositors instead are the suppliers, who get paid for supplying money to the bank.

You may be wondering what about the other bank services? The short answer is that there are a limited number of depositors out there and banks need to retain their depositors. To do this they implement a wide range of services that cater to their depositors’ needs, namely money management solutions. It’s a bonus that they can also make additional profit from providing these services.

So how does a bank fail? You see, banks will always want to lend out as much money as possible. The more they lend out, the more interest they make, and the more profits they make. However, their depositors will also need to withdraw their money at different times. While only a small portion of depositors will be withdrawing at any given time, a bank still needs to ensure depositors have access to their money. Otherwise the bank risks running afoul of the regulators whose role is to protect depositors.

This reserve of money supply in the bank then presents a challenge for the bank to balance. Too much reserve means a waste of assets. Too little and the bank may not be able to handle an abnormal spike in the amount of withdrawals.

In SVB’s case, they were sitting on a huge supply that could not be loaned out quickly. Unutilised assets are not good and so they decided to lock a big chunk of their money in long-term investments. Unfortunately, due to a number of factors, their depositors lost confidence in them and were looking to suddenly withdraw about $42 billion (out of $212 billion). This pushed SVB into a negative cash balance. Their attempts at raising funds failed and then the regulators stepped in and closed them down.

As investors, this SVB collapse does not have much impact to us because SVB was not that big of a bank all things considered. However, faith in the financial industry has been shaken.