A bank or mortgage company is nothing more than a box in which to keep money. The owner of the box will have to do some calculations. First, how much is he going to offer people who keep cash in their boxes, in exchange for such a deposit? Second, how much money should he keep as cash if the owner of the cash wanted it back? Maybe 5%, maybe 10%, what are the regulations in the jurisdiction? Third, how much will he charge people who want to borrow other people’s money, previously stored in the box?

The person who owned the box then set out to find many other people to put their spare money in the box, in return he promised to give them their money back plus interest. In the eyes of some economists, these people are lenders and not investors. This terminology is based on the fact that the lender’s equity participation does not change, while the value of the investor’s capital, in shares or property for example, can go up or down. The box owner must then find someone else who has no spare money, but really wants to borrow it.

Fixed or variable?

Both lenders and borrowers can sometimes be confused by the various terms offered by these institutions. The easiest term to understand is one that is based on the current rate which will vary according to the market for interest rates, which change daily, although the company will try to even out such daily fluctuations with only periodic changes in rates. Fixed rates, for a given period, are more difficult for the average lender or borrower to grasp, a fact which has given rise to in the past for greedy companies that could reap the greatest benefits of such a lack of knowledge. The reason why agencies want to withdraw fixed rate deposits can be based on the fact that their advisors calculate that interest rates will rise. If they find it possible to withdraw deposits at say 3% for 3 years, and then discover that the current rate is 5%, they will be somewhat pleased. In case the borrower finds that they are in this situation they should be congratulated for being better at guessing than corporate advisors. On the other hand, borrowers who are tied to a contract at say 10% for several years who later find that the rate has fallen to 5%, will not really celebrate. In my brief experience since I started at university fourteen years ago, I have seen deposit rates vary from 14.5% down to 1.5%.

Are banks safe?

There is also a general belief among lenders that their capital is safe. In the absence of a government or similar state authority providing such guarantees, this could be far from the case. At the university one of the cases we studied was a certain savings bank. A rumor is circulating around town that the bank is in trouble. A large number of people go to the bank to withdraw their savings. Those who represent the first few% of the total deposit have no problems. When the percentage rises to 6%, which in this case is the amount decided by the “box owner”, the rumor becomes the fact that there is no cash to pay the depositors. Since this is in a country where the owners of all the boxes are members of the club, aiming to protect the underserved, but perceived, reputation of the members, the members send a round security van with enough cash to pay for everyone who “has noticed the rumors that groundless.” Things calmed down after a while, and the government decided to introduce legislation to create a minimum level of liquidity.

Another case we studied was one of the largest banks in the world, whose board consists primarily of greedy souls. They have decided that the stock market is a good place to maintain liquidity margins, so that if a bear market occurs, they can create more profit for shareholders. The bear market suddenly wiped out the liquidity margins, and banks came in a broad hair going belly up.

Once a bank reaches a substantial size, liquidity must be large enough to serve all these panic withdrawals, unless of course the panic was as great as 1929.

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