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Everything you should understand about banks and deposits

20min read

Hi, I'm Jordan Gonen. I'm the CEO of Compound Wealth Management and I'm here with Patrick Mckenzie who writes the Bits about Money newsletter all about financial infrastructure. Financial infrastructure powers all of our businesses and lives and is generally a very reliable thing. It also undergoes periods of extreme stress. 

And the US is at the early stages of what may eventually become a very broad banking crisis. We want to help you understand how the banking system functions so that you can understand all of the news this week, take appropriate actions for those you owe duties of care to, and worry less about a topic that feels outside one. 

A quick disclaimer:

We've both worked much of our careers at the intersection of technology and finance. Essentially everyone who understands how the financial system works is very conflicted by the relationships they have in it. We have our own professional relationships and are speaking purely in our personal capacities rather than as representatives of any entity.

This is not direct financial advice, and we anticipate the next few days having swift developments and point you to the government and the media for up-to-minute information. But we wanted to contextualize all of this, with the benefit of our experience and the distance of not actively being engaged in firefighting.

What is the purpose of a bank? 

Banks provide a bundle of goods to society. One of the things that people pervasively underrate is that while banks, at least here in the United States, are largely private institutions, they operate as a public-private partnership with the government.

They're creatures of state action. They respond to policy goals of the government.

At the highest possible level, the purpose of banks is to co-create this thing, money, that we all depend on. You might think of money as being printed by the mint or created by the Fed.

Those are lenses of it, but another true lens is that credit creation is what really drives the money supply in the United States and most other nations. And credit creation is a function of the regulated banking system and of commercial banks. The phrase “commercial” bank just means the kind of bank that you are likely to have an app for versus a national bank like say, the Federal Reserve or the Bank of Japan.

The most important function of banks is creating money, but they also provide a number of products and services that basically everyone depends on. Substantially every business depends on a banking relationship. The infrastructure that is built on top of banks touches everyone.

Banks are a place to store your money in an account. They allow moving money around in a transactional fashion, and they give out loans, which allow you to use your crystallized earning power to purchase things in the present with money you will earn in the future.

For example, you might have a mortgage. Your businesses might want to do capital investment without raising equity, etc. 

That is a quick gloss of the functions of banks, but they actually go on a bit longer than that. The thing you should understand is that banks are very critical to society, even if you don't work at a bank or aspire to understand how they function.

How do banks make money? 

Banks make money in a few different ways. Here we're talking about making money in the usual sense of a business. It's a different discussion to talk about how money supply is created through credit creation.

The most salient way banks make money is through an interest rate spread. Banks manufacture loans for individuals and businesses in the broader economy. 

These loans are made up of a few ingredients.

One of them is equity, which is the money invested in the bank by its investors. The other is typically a lower-cost source of funding than equity, of which the dominant one is deposits.

As an oversimplification: when you put your money into a bank and allow it to rest there, the bank will aggregate it with money from many other people. This smooths out the bumps in your individual needs to access your own money, and allows the bank to borrow some for its own purposes. That purpose is to re-lend the money.

Then the bank loans out the money and captures a spread, which is the difference between the interest rate that they charge the entities that borrow the money and the interest rate that they pay you on your deposits at the bank. If you have a checking account, your interest rate is probably very close to zero. If you have a savings account or a few other types of banking products, you might earn a small amount of interest.

For many years, the interest rates for savings accounts were just fractionally more than zero. In the last year, the rates have been around 2 to 4%. When the bank loans out money at higher interest rates, such as a 3% mortgage or an 18% credit card, the difference pays for the expenses of generating the loan, running the bank edifice, and eventually making some money for the bank.

What are the primary types of banks in the US and how do they differ in structure? 

Sure, let's start at the small end and move up to the large end.

It's worth noting that the US is idiosyncratic in how the banking ecosystem works. The US has two general types of regulated deposit-taking entities: banks and credit unions. While I'll mostly be discussing banks, credit unions are also an important part of the financial system, though they are often considered separate by those who work with them.

The US banking system is different from those of other countries for a variety of historical, cultural, political, and economic reasons. One of the unique features of the US banking system is the sheer number of banks - there are several thousand of them.

Most of these banks are community banks, which are similar to the local savings and loans depicted in "It's a Wonderful Life." These local institutions typically have between $100 million and $1 billion in deposits and primarily serve the needs of a specific local community, which could be a town or a county.

One of the reasons that community banks are considered such a core part of the financial system is that the United States is a very big country, which includes both diverse populations and diverse areas within it. Community banks extend the reach of the banking system, and the financial infrastructure that the banking system represents, to the far flung places of America. One thing their advocates will quote, exhaustively, is that community banks operate the only branches that are available in about 20% of the counties of the country. They are less core to the banking mix in e.g. cities, where it is economic for other classes of banks to operate.

Moving up in size, we have large regional banks. These are typically created through a process of banks gobbling each other up over the course of decades. They cover a few states in a particular region of the country, but do not have a nationwide franchise and are not among the largest banks in the world. Fifth/Third Bank is an example of a regional bank that you may have heard of if you live in the Midwest.

Finally, we have the largest banks in the world. They are globally significant institutions that not only take deposits and make loans, but also have capital market functions, like e.g. bond underwriting. They are essential pieces of financial infrastructure that the rest of the banking system, as well as the rest of the world, depend on. Examples of these banks include Chase and Bank of America. These are the banks that are popularly considered “too big to fail”, meaning that they’re so interwoven into the financial system that they’re indispensable, and that the government knows it.

As a customer of these banks, what are the different options that I have for my money? I hear words like checking account, savings account, money market account, and treasury bills, but how can I differentiate between them and what are their purposes?

There are many places to park your money within the banking system, each with subtly different restrictions, regulatory regimes, and levels of protection. However, the most important thing to note is that the system is designed to be extremely resilient and your money is likely safe wherever it is right now.

That being said, if you are responsible for treasury management at a business or have a lot of money that you need to pay employees, it's important to understand the differences between various instruments such as money market funds and checking accounts. Most people don’t need to know the minutiae, just like most people don’t need to know where Google’s SSL certificate comes from.

In general, banks offer reliable access to your money on the terms that they promise. Checking accounts are typically used for day-to-day expenses and come with check-writing abilities, while savings accounts offer higher interest rates but often have withdrawal restrictions. Money market accounts are specialized investment accounts which are de facto as safe as cash but may offer a higher yield, which they get by investing in high-quality securities.

How should I interpret what FDIC means? Why does FDIC Insurance exist and how does it play a role in the banking ecosystem? 

So as we mentioned, the banking system periodically goes through periods of extreme stress—both at an individual institution level and a broader systemic level.

We are unfortunately seeing an issue that started at individual institutions which may become somewhat systemic over the next couple of weeks. The idea behind deposit insurance is: if we have systemic problems, we need systemic solutions to put in fire breaks such that the failures at an individual institution don't cascade and hit the rest of the system.

One of those fire breaks is the deposit insurance scheme. If people think that a bank has failed (i.e. it no longer has sufficient liquidity to make its depositors whole) as the depositors try to get their money out they will trigger what is called a “bank run.” A bank run is when many customers withdraw their money from a bank at the same time. This is often driven by a fear that the bank might be insolvent, meaning that it could simply run out of money to pay depositors back, and that therefore being the first in line is safe and the last in line gets nothing. Bank runs are collective action problems, because if you think your bank is undergoing a run, you rationally should join the run.

Bank runs are extremely concerning, but these days they are extremely rare. The reason we are currently discussing them is that one killed a bank recently, in a surprising fashion. Deposit insurance is one reason that runs are now rare; they used to be much more common.

Deposit insurance exists because runs kill banks. There is—to a first approximation—no commercial bank that can survive a bank run. So, to make banks robust against a phenomenon that will almost inevitably kill them if it gets going, you want to decrease the number of runs and decrease the size of them.

We do that by having more than one institutional commitment strategy. One commitment strategy is by the FDIC, which is America's Federal Deposit Insurance Corporation. They effectively collect a tax from all banks, every quarter, based on how large they are. They put that tax in a pot, called the Deposit Insurance Fund. Most of the time, the money sits in that pot and does nothing.

If a bank fails, the FDIC will do some things to attempt to make depositors whole. The most likely thing they will do is arrange a sale of the failed bank to a healthier bank, and in most cases this makes all depositors whole without any cost to the insurance fund.

The backstop to the preferred resolutions actually taps the fund: while dealing with a substantial amount of operational trivia, they compensate depositors for deposits they had which the bank couldn’t repay. There is a cap on how much they compensate. You can round that insurance limit to $250,000 for each deposit in a bank. (The limit may vary depending on the type of account or structure of the account, but most of the time it is $250,000, and attempting to understand the full rules is a task only for banking structure nerds.)

After that, if the bank fails, there is potentially some notional risk of me losing the money that I have in a particular bank above the $250,000 limit. However, avoiding that is a major policy goal of the government and of the banking system. [Note: this was recorded prior to the FDIC’s decision to waive the limit with regards to two institutions which failed recently.]

We should talk a little bit about the mechanics of what happens when a bank fails though, because, while one might not actually realize a loss, one could have interrupted access to money (for example).

So in the scenario where a bank does fail, what does the FDIC do to get people access to their assets?

Banks don't fail overnight. The fact of the failure becomes known overnight. Often, the run—the spark that lit the fire—might be a very sudden event. The kindling was laid long, long in advance. And hopefully, the bank is aware of that and the regulator is aware of that.

The bank has likely been on a “watchlist” for a while. When a bank is beyond saving, typically on a Friday, their regulator will tell them: “Your bank has failed. We are shutting you down.” Simultaneously with that action, a lot of FDIC people show up at their offices.

The FDIC's brief is: “It is Friday. We are going to work through the weekend with the bank staff and with other banks to attempt to get this institution in place such that banking resumes on Monday, without interruption.”

The primary goal of the FDIC is to ensure that depositors receive their insured money back, on Monday, “come hell or high water”. This is what the FDIC exists to guarantee. It usually performs better than that promise.

Over the weekend, the FDIC will look for a resolution that gets all of the money back, usually through arranging for acquisition by another bank. 

So banks have basically two sides of the business, and you can think of it as a factory and a warehouse. The factory is engaged in the business of banking. One of the things that it occasionally produces is loans. Some loans are sold, just like most products of most factories, but some go in the warehouse. And the warehouse owes money to people, including depositors, for those things it buys from the factory.

You could imagine a warehouse filled with less-than-valuable things, like shirts which are out of style or bonds which have declined in value since being issued. But regardless of how toxic the warehouse is, the factory is worth money if it can still manufacture valuable things.

So let’s assume that the warehouse is completely hosed, which is not necessarily true but might be true in this situation. Even if the value of everything in the warehouse would be negative (after you pay back the people the warehouse owes), the factory still has value, and the FDIC's first inclination for resolution is to go to other banks and say, "We want you to put up some money. You get the factory for free in return for paying the negative balance that's in the warehouse."

Banks want the factory. In the non-metaphorical world: they want the branch footprint, and the trained staff who are already employed in those branches, and the desirable customers who trust those staff and will buy their next mortgage from them. These are valuable things, and they took years of very patient work to build, and the acquiring bank can save themselves years of patient effort by just writing a check.

This successfully resolves most bank problems, without even requiring the backstopping funds from the FDIC. It isn't 100%, but that is the most likely outcome.

Most banks that fail are community banks. They're relatively small institutions. They have relatively small holes, and they have a larger community bank or a larger regional bank that'll say, "Okay, we could expand our branch footprint a little bit by buying this failing bank, and the government might give us sweeteners to make that transaction happen. So this is an opportunity for us. We had a plan to grow, and this gets us where we want to be faster, cheaper, and with less execution risk."

Not every bank that fails is sold. In the case where the bank is not sold on Monday, by Monday the FDIC will have created a successor bank. This successor bank's job is to continue operating business as usual while things get sorted out.

What does business as usual mean? It means your checks will continue to work. It means that when you call the bank, you'll speak to people who work at the new bank. They are mostly the exact same people who worked at the old bank on Friday. They still remember your kids’ names. The coffee even tastes the same.

And the money? You have some money, with the exact amount mathed out by the FDIC over the weekend. It will include the insured amount, “come hell or high water.” For businesses and rich individuals, who had more than the insured amount on deposit, the FDIC will give them immediate access to some amount of funds and then an IOU for the rest. That IOU may or may not be satisfied in full as the FDIC tries to work things out over the coming months.

The FDIC is not in the business of operating banks for decades. The new bank will either eventually find a buyer, or it will allow its customers to migrate their affairs off the bank gracefully and then shut down, or there is some chance that it will continue as a free-standing institution, spun out of the FDIC’s conservatorship and back into the private sector.

What do you see as the impact of bank consolidation? What happens in a world where many of these smaller banks end up failing?

So, we are not yet in a world where many of the smaller banks end up failing, and thank goodness for that. Historically, when bank failures happen, they've been smaller banks.

The classic reason that a single bank fails is due to idiosyncratic reasons. This means an individual bank made individual decisions and faced an individual circumstance that had negative consequences for it. Usually this means they have taken a bit too much risk.

They might have failed to do financial structuring well, or it may have had a localized economic event—e.g. if you are in a town that has one employer and the one employer pulls out of the town.

So, individual banks fail. Systemic failures—when things ripple between various institutions—happen because the financial sector is increasingly interconnected with itself.

The larger banks, banks that function over a variety of industries, have a larger footprint and are more insulated against idiosyncratic risk that may be caused by individual industries. They’re also more closely watched by regulators and, one would hope, just generally better at managing their own risks. However, by nature, they are at higher risk of having the influence of other institutions picked up and magnified into them.

And so we have many complicated tradeoffs to make in market structure here. The United States has ended up with a hybridized system. It has both very large banks (including many of the largest financial institutions in the world) and also a huge number of relatively small banks. 

We are currently seeing stress in the segment that is between those two extremes: the large regional banks. The large regional banks are large compared to community banks. A community bank could reasonably have only a single branch or perhaps a footprint covering a few towns and some surrounding farmland. But a large regional bank is still tiny next to the largest banks in the world. They have individual business units that are much larger than everything that bank does put together.