Intelligent Investing #70 Glenn Leest, The US Banking System Part 1

The US Banking System Part 1

1.      Why are you doing an episode on the banking system?

o   With the recent failure of SVB and other banks, educating my clients and others about how our banking system works will help us be better investors.

o   The more you understand about our monetary, the more you will be able to understand what is happening with our money and why it is happening.

2.      What is the US Banking System? 

o   The banking system is a network of financial institutions that provide a variety of services to individuals and businesses. The basic function of banks is to accept deposits from customers and use those funds to make loans and investments.

3.      So the banking system takes deposits of its customers and invests it and loans it out? Can you walk us through how that is done?

·         The US banking system creates new money through the lending process in a few ways:

o   Fractional reserve banking: Banks are required to hold a fraction of their deposits as reserves, but they are allowed to lend out the rest. This means that when a bank makes a loan, it creates new money by increasing the borrower's account balance. For example, if a bank has $100 in deposits and a 10% reserve requirement, it must hold $10 in reserves and can lend out $90. If it makes a loan for $90, the borrower's account balance increases by $90, and the bank's liabilities (the borrower's deposit) also increase by $90. The bank now has $100 in deposits and $90 in loans outstanding, which means it has created $90 in new money.

o   Interest: Banks charge interest on loans, which means that borrowers must pay back more money than they borrow. This increases the money supply because the additional money paid back in interest did not exist before the loan was made.

o   Secondary market transactions: Banks can sell the loans they make to other financial institutions, such as investment banks or government-sponsored enterprises like Fannie Mae and Freddie Mac. This can free up the bank's balance sheet to make more loans, and the purchasers of the loans can use them as collateral to borrow additional funds. This process can increase the money supply in the economy.

o   Overall, the US banking system creates new money through the lending process by expanding credit through fractional reserve banking, charging interest on loans, and facilitating

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Transcript

The following is paid programming brought to you by WT Wealth Management. Nothing we discuss should be considered as investment advice. This conversation is for informational purposes only. Please do your own research and speak to an investment advisor or financial planner before making any investment decisions.

All right. Welcome to Intelligent Investing with Glenn Leest. I'm your host, Jeff Orbits and uh, Glenn, welcome. Um, we've got a big one here. It has to do with the banking system, and I think that's something that is on a lot of people's minds nowadays, especially with what's happened recently. So, yeah, absolutely think of your goal.

To do this over two parts because it's quite a bit. So, starting with the US banking system and then moving on next week I guess to the Federal Reserve. Yeah. And how all that works. Yeah. Fun stuff. Yeah, it'll be fun, but I think it'll be enlightening and um, really help the listeners have a better understanding.

Because the more that we know, the more that we can make informed and educated decisions. So, that was kind of the, um, the thought behind doing that show. And, and the other thing I was going to say is we've been doing a lot of client meetings, um, and probably the last 15 of 'them I'll ask, hey, Do you know how the banking system works?

And they kind of look at me and go, mm, kind of, and so, um, I explained to 'them kind of all the ins and outs. They're like, oh, okay. Now this is making sense with maybe some of the recent, um, banking troubles that we've seen on the news. So, um, yeah, I think it'd be a great, great topic to explore more. What banking troubles.

I, I don't, I don't remember any. Yeah. Well, there's been a few. Yeah, there, there's absolutely been a few. And, um, so, you want folks to learn more about the, the monetary system and, and, um, one of the most important things. Out there. So, I guess the simple place to start, Glenn, is what is the US banking system?

Maybe give us all the Yeah. Nuts and bolts on that as best you can. Yeah. It's just a framework, uh, financial institutions that, um, provide a buyer variety of services to individuals and businesses. They take in deposits, they make loans, um, they do investments. Um, and really that kind of just sums it up.

They, you know, Bunch of different financial, uh, services that they offer and, um, bunch of different banks. I mean, in every town there's probably like 10, 15 banks, you know, there's quite a few. So, yeah, they're everywhere. And then, we'll, we'll get in next week to the, the Federal Reserve System, um, and, and, and go over that a bit.

Um, so, it takes the deposits from its customers, right? Yep, yep. That's one of their functions. That's one of the functions. And then keep it safe. Safe, right. That's the idea, right? Is they take the deposit. So, you would hope safe. Uh, yeah. Yeah. Because you don't want to have six figures of cash somewhere at your house.

That's probably going to make you nervous. Um, so, you, you give it to a bank, and they also provide some security, um, or at least protection from someone coming in, stealing it. Yeah. Um, what you're alluding to is a whole other subject. Well, yeah. Yeah. Keeping it so, because they loan out, they loan out the money.

Mm-hmm. Yeah. And so, I guess talk about that a bit. Yeah, so, I think that's the one area when I ask, uh, people about that they're probably the most unfamiliar with is, uh, how banks function in that capacity. So, they call it fractional reserve banking. And what that means is, um, each bank has a, uh, reserve requirement.

Meaning what percentage of that deposit you just made do they must keep on hand available? So, say you deposit a hundred dollars into your local bank and there, uh, reserve requirements 10%. So, that means they only must keep $10, uh, on hand at the bank, um, or. On their books and they can line up, uh, loan out the other 90% or they can invest the other 90% or $90.

So, um, yeah, you have that $90 and say another person comes in and you say, I'm going to loan you $90, uh, and here's $90, and you charge 'them interest. That's how they make money. And then that person takes their 90 that they had just got loaned deposited back into the bank, and now the bank can loan out on that again as well.

So, uh, sounds like it could. Uh huh. Exponentially. Yeah. Yeah, yeah. That's where, that's where the, it starts to get complicated. So, in that last scenario, the person that deposits $90, you can then loan out 81, and then the next customer, if they deposit the money right back into your bank, you can loan out, you'll have to keep 10% on reserve.

So, on 81, that's, um, what is that? Uh, $74 is. 70, yeah. 73. Yeah. Something like that. You can see they just keep doing that over. Yeah. Yeah. So, um, the important thing to, to recognize is what is that fractional reserve for that bank? And, um, because that, that determines a lot. And then what are they doing with the money too?

Because they have a whole, a bunch of different options. They can do the loaning process and they charge interest, which is how they make money. They can also, uh, do investments too, so, they can take the money you deposited. Invest in it. Um, now investing is a broad, broad term. Uh, most banks, when they invest, quote unquote, they are usually buying very safe assets like treasury bonds or fixed income products.

Usually buying high risk stocks is, uh, kind of frowned upon because it's so easy for it to go south. And, but they could, they could. Yeah. Yeah. Yeah. And uh, I think that was part of the 2008 problem with Lehman Brothers is that they. Making risky loans on those subprime mortgages, and then they're investing their money back into it as well.

So, it was like a house of cards. It was just doomed from the beginning because of that, that reason. But even the safer, is that what happened with Signature Bank and these couple banks because they were investing the quote unquote, safe assets to treasuries. Yeah. But then interest rates spiked.

Mm-hmm. When they raised interest rates nine or 10 times over the course of a year, a few times. So, then those old treasury notes that they invested in maybe six months or a year before were worth less. Yeah, yeah. Yeah. And they kind of, that they kind of got themselves caught in that. Yeah. So, here's a good example.

Um, so, person deposits money. Bank and you say, let's use the same a hundred dollars. Um, we can add just a bunch of zeros cause its easy math that way. Mm-hmm. But a hundred dollars and they take 90 of it and deposit it into a, uh, US Treasury, which is just a loan to the US government. And it paid you say, 3% to maybe, you know, a couple years ago and you, and you lock it in for 10 years.

But then they've been raising interest rates, uh, since then. Yeah. And now that same, uh, loan or loan to the government is paying four, four and a half percent. And so, your 3% bond is going to naturally have a, uh, price discount if you must sell it. Uh, but if you keep it until maturity, it's, it's, it doesn't matter.

You get your principal back. So, uh, so, SVB Bank had a bunch of those, and they were just planning on holding it to maturity. And the problem they got into is they had to make. All those, uh, withdrawals. Yeah, they did. They had to facilitate all the withdrawals from the customers. Yeah. And to facilitate that, they had to sell all those, those, uh, fixed income products and they sold it at a massive loss.

Okay. Um, and, and so, that was part of the, the big issue there is, well, only if you think about any bank would probably have trouble if everyone pulled out their money simultaneously, because no bank has a hundred. Of all the cash on hand. Yeah. That's just not how the system works. Or even close to 10% by what you were talking about Glenn.

Right. I mean, so, classics run on the banks and people demand their money and get nervous and then force them to sell the assets they had at a discount. Yeah. And um, I, I thought we learned as a nation not to do bank runs, but maybe we're learning it all over again. Because any, like I said, any bank, um, it's going to put pressure on them.

Mm-hmm. To, if every single person tries to pull up their money simultaneously, they're going to have to try and, you know, sell off a bunch of stuff and probably sell out a loss call in all their loans and notes and it's just going to be a disaster. Now, some banks are better than others as far as. Um, how much they keep in reserves.

Sure. And so, that's where the next, um, layer of, uh, when you're looking at a bank of what's important is, well, what are there, um, what do they have reserves on hand, um, that are available for, um, uh, deposits to make good on those? Or, or sorry, for withdrawals. Withdrawals, yeah. Yeah. Yeah. And so, um, S P B was like 93% of their assets or something like that was.

Uh, loaned out or invested and so, yeah. Not liquid, not readily accessible. Yeah. They, they had like seven or 8% Yeah. Um, available on hand. And so, well then you had billionaire like funds and stuff going in and saying, I'm taking my money out. I think Peter Teal was one of those and yeah. Um, and then the next person’s like, well, I, maybe I should do that, because each bank account, the stickers on the window.

Yeah. $250,000. Yeah. Right, right. I guarantee insurance. So, people would get nervous if they had more than that. Um, do you think it's over or, I mean, nobody has a crystal ball. I saw Warren Buffet was talking about, hey, he thinks more may be coming, but, uh, the Feds moved quick on that one. Yeah.

Yeah. I think like before they implemented the, uh, F D I C backstop, um, I'll have to double check the dates. I want to say it was in the early 19 hundreds, but before that, they were having like 10,000 banks fail per year. Mm-hmm. And then once they implemented the F D I C, kind of as a fail-safe, then they were like having 10, 10 or less banks failed per year.

So, it that guarantee by the government and the, the Federal Reserve. Brought a lot more safety and stability to the banking system. And so, as you're alluding to, um, Silicon Valley Bank, uh, one of the big names out there looks like they're going to get bailed out and they're going to  get some help, um, from, uh, the Federal Reserve, the government.

And whether that's right or wrong is a different conversation, but that's kind of what it looks like is going to happen. And it happened in 2008 too. Yeah. They are too big to fail, is what they said. Yeah. And they just bailed out the banks for. What was just bad behavior on their part. Okay. Let's get more into, and you're listening to Intelligent Investing with Glenn Lease, um, the secondary market and how banks sell their loans, I guess mm-hmm.

When you make a loan. So, I want to get into that a little bit more. Uh, and if you've got any questions for Glenn, give him a call at (928) 225-2474 and you can always the mail as well intelligent investing@wtwealthmanagthement.com. Okay. So, we, we talked a bit about how they get the deposits in and how they. Then can, um, loan out that money and they only keep a, a certain amount, usually 10% on the books or so, uh, charge interest on loans.

Mm-hmm. Um, which means that the borrowers pay back. So, so, talk, talk about that. You make a, you, you make a loan. You, you think a lot of times that they keep that in their books forever, that the bank. Um, you know, a lot of times he's going to have it at Glenn's bank, for example. Yeah. A lot of times banks sell their loans.

Okay. Where they say they do a mortgage and they get it approved and, you know, everything's good to go. And they may say, as a bank, you know, really, we really don't want to hold this mortgage for the next. 15, 20, 30 years. We'd rather just sell it to another institution, another financial institution, and just get, um, all that money back and we'll, and maybe they'll make a little bit of money on the initial purchase, the upfront interest, that sort of thing.

So, that happens commonly. Um, you may have even had that happen in your more mortgage is that I have suddenly you see a different name on your mortgage statement. It means you; your loan was sold. Yeah. And so, some. I, I knew this from a car dealership I worked at a long time ago, is they would make the loan and then like 30 minutes later they'd sell it.

It's gone. Yeah. Yeah. They'd sell it as soon as it got approved. They, they did not want to hold that loan, which made me, you know, wonder why, why didn't they want to hold that loan? Was it a bad loan or they just weren't in the business for long-term loans? I don't know. But they make some fees on the loan and they just get it off their books.

That book too. Yeah. Yeah. So, the banking system, um, you know, they can also, Sell out those, those debt products. So, which they were doing in 2008. Uh, 2008 is the CDOs and mortgage-backed securities, all, all those kinds of things. Um, they were just selling the debt to other people. I remember, uh, alone. Yeah.

It was, um, bank X for example. Mm-hmm. And, uh, then you get the first statement maybe from them, and then there was just, somebody else is like, oh, we're your, we're your mortgage holder now. Yeah. Yeah. You're like, choice. Who are you? They just, yeah. You don't, you don't, and you're like, okay. I, I guess that's how it is now.

Um, okay, so, how do, before we go to break here, Glenn, um, how is new money created? Yeah. Because we oftentimes think about the, the old printing press. Mm-hmm. It's just zipping out new a hundred dollars bills or $50 bill. Um, but there's another way. Yeah. So, there's a printing press, there's a computer on the keyboard.

Yeah. Just add some zeros. Just add some zeros at the, at the, uh, federal Reserve level. Um, the other way is through the banking system. Uh, the banking system creates a tremendous amount of new money. And so, let's go back to that example of. Uh, a hundred dollars gets deposited. Uh, it takes 90 of it and loan it back out.

Okay? That person takes the 90, you know, deposits loan that back out and continue and so, forth, and so, forth. And then suddenly now you have all these dollars that were created off that original dollar. And so, it creates money, um, by that process, by the fractional lending process itself.

They can create new money. Kind of just thin air. Yeah. So, um, it’s, I never knew that until a couple years ago and I was like, wow, that's fascinating. Banks create money. Yeah. They're the ones that do it through commercial lending. Through the lending process? Yeah. Through the, yeah.

Just they can do it through consumers, commercial mortgages. Okay. You know, whatever they want to do. Because um, when they get that deposit back in, after they've done the loan, now it comes back on their balance sheet as a positive and they can loan back out and then, more gets added. So, it's just this ongoing process of where they, you know, started with a hundred dollars, but then towards the end maybe they have $175.

Yeah. Um, because a bunch of how many times they loan that, and you multiply that by, you mentioned all the banks that are in this country. Yeah. And every, in every community, um, of, of course it's not just your banks, you got credit unions, things like that. Yep. All the same. So, yeah. All, all really the same.

Um, I, another topic we should probably do another time, Glenn, would be the, you know, how there's been a push for essential bank digital currency. Would that take out the commercial banks from creating this process and, and, you know, creating money, I guess out thin air. And then, then it's the, the, the federals, the feds just doing it directly all the time.

Just food for thought. I mean, it's, yeah, because there's a push for that right now. Yeah, if you change the dynamics of the fractional lending system, it’ll, uh, make less dollars that are created, uh, in that process. So, yeah, if the federal government says, you know, we're going to have the Fed dollar or the Fed coin, whatever it may be, um, and that's the only way you can loan out, we'll just do all the loans.

That seems not up there. Alley. Yeah. So, this is a big task. It is. I wouldn't want to take on all the loans. Do they still have another, another topic for another day? Well, let's get into, uh, when we. Some of the other services that the banks offer. Yeah. Um, the guardrails, I guess the supposed banking regulations and all that, that's supposed to protect everybody out there.

Mm-hmm. Uh, and you're listening to Intelligent Investing with Glenn LEAs. Uh, give Glenn a call, uh, 9 2 8 2 2 5 24 74. That's 9 2 8 2 2 5 24 74. And you can also send mail. Intelligent investing at WT Wealth Management. Don't go anywhere. We got a lot more to come back in just a few minutes.

You're listening to Intelligent Investing with Glenn LEAs. Give Glenn a call right now at (928) 225-2474. That's 9 2 8 2 2 5 24 74. More intelligent investing with Glenn Leest when we come back.

Welcome back. You're listening to Intelligent Investing with Glenn Lease. Glenn. Make a call at (928) 225-2474. Also, the mail intelligent investing WT wealth managthement.com. We're talking about the banking system. Next week we'll get into the Federal Reserve a, a bit more. Uh, but before we move on, Glenn, talk about some of the guardrails that are supposed to be there with banking regulations.

Uh, what other things do, do we get from the banks? I mean, what are the, what are the services? Yeah. So, just kind of round out the whole topic. Yeah, yeah. Then, I mean, banks offer credit cards. They offer mortgages, uh, investments, most banks do. Um, they also, uh, in addition to that, do payment processing. So, you got your debit card or credit card, you swipe it at Starbucks, Starbucks.

You know, charge $10 and goes to the bank electronically. Yep. The funds are there. Process it through. So, they facilitate the, uh, sending of money electronically, back, and forth. Um, and then even checks as well. The same ping. And so, that's the other thing that they do, in addition to what we talked about, is not just the loans, the deposits are, uh, some of the other ancillary services.

Students still write checks. I still have checkbooks. You still do? Yeah. Yeah. I'm sure they do. I see. I find their use occasionally. Um, my wife says we have someone somewhere, one singular check, you know, one check just in case they make a lot of money on those fees, on those debit and credit card transactions.

Oh, yeah. I don't think a lot of people realize that. Uh huh. Yeah. And some of 'them are. Two percent-ish can be as high as three for some credit cards. Um, and evidenced by, if you've ever had a credit card and you do a cash advance or whatever, they charge you that three or 4% upfront. Um, the other times when you're using your card, you may not see that 3% charge.

It's because the merchant is absorbing that and raising their prices accordingly. Yeah. So, yeah, the banks are making money on the transactions. I mean, visa and MasterCard. Absolutely monstrous. Breaking it in. Yeah. Yeah. And everything's really a little bit more, two, 3% more if you think about it.

Yeah. Um, because everybody uses that card. Even nowadays for a cup of coffee, it's hard. You rarely see people whipping out some change or a couple dollars. Yeah. That's why you see those signs where it's like, if you're purchases less than $5, we're going to attack on 50 cents. Yeah. It's because of the minimum transaction fees that they incur.

Like if you just buy a pack of bubble gum with, uh, your debit cards, they get a little annoyed. Yeah, probably losing money because there's like a, yeah, there's that minimum fee. Like you said, it just cuts into their profit marketing. Yeah, exactly. Um, okay, so, the guardrails, uh huh and banking regulations, and a lot of us, a lot of people listening are familiar with 2008 and how the system really failed.

So, there's supposed to be regulations out there that protect people from failures and yeah. Bad doings of, of banks if they get into trouble and invest in things and. Not supposed to talk about that a bit. Yeah. So, one of the other jobs of the Federal Reserve is to oversee the banking system and make sure it's, uh, there's stability in it.

And so, the Federal Reserve implements several. Um, criteria that the banks need to meet. Um, and, and one of 'them is their capital requirements. So, the minimum amount they need to have is that buffer. They'll set, okay, here's the amount of money you need to keep, uh, in case that you incur a loss on your investments, that sort of thing.

Um, and then additionally, on top of that's liquidity requirements, um, how much you have liquid available to make the deposits. Um, because you can. Say 10% available, um, for withdrawals, uh, of your total assets, but you only need liquidity of say, 5% because the other 5% is just sitting there as a buffer.

Mm-hmm. Or whatever the case may be. So, you've got your liquidity requirements. And then they also, the Federal Reserve manage, uh, overseas banks and does a lot of risk management. And so, they look at. What they're doing with those deposits that come in and say, are you being overly risky and are you, um, being, uh, prudent with some of these, the dollars that are deposited in?

And if they're too risky or they're over-extended or they've been over lending, they will, um, impose changes. You know, say, hey, you're required to make these changes to your system. Um, and I think maybe in the last couple years they've been. More friends at the bank. You know, the federal Reserve was like all kinds of buddy-buddy with a lot of the big banks mm-hmm.

And banking systems. But they’re, they're the overseers. They're the, you know, the supervisor, if you will, the boss. And so, at times they got to, you know, act, say we must make a change, you're otherwise going to be a big problem. So, sometimes they miss it. And then, but then sometimes Silicon Valley banquet you mentioned Glenn, they had to go in and say, we're taking over.

Yeah. Yeah. So, I mean, uh, By, by, by the Federal Reserve, not enforcing their policies more strictly. Um, which is I think what, what was kind of happening a little bit? Um, it just made it so when banks run into trouble, the trouble was magnified. Yeah, yeah. Because they're already kind of in a. Predicament, if you will.

So, um, yeah, so, those are some of the things. The Federal Reserve is, you know, monitoring their risk, monitoring their liquidity, you know, monitoring there, um, reserve requirements and are they cash on hand? What are they doing with their deposits? Are they buying, uh, treasury bonds or are they buying, um, stock and some tech startup companies or something?

Yeah. Trying to make up the laws. Yeah. Yeah. So, SVB was interesting because their loans were primarily to startup companies. Mm-hmm. In fact, uh, about 50% of all startups, uh, in United States got their funding from sub, so, that was like their bread and butter. Wow. Um, and, and startups are risky. Um, yeah, hopefully you get your money back, but there's a chance it goes under, and business fails and, you know, they default from the loan.

So, the ramifications of that might be felt for a while. As far as startups who were expecting money, or maybe they're still doing it, they're still in existence. The feds have just taken 'them over, but I wonder if that spigot kind of was cut. A, as far as funding, uh, for a lot of startup companies going forward.

Yeah. So, um, I think a lot of the banks looked at that scenario and might get a little bit more gun shy. Yeah. A as far as making riskier loans and just be a little bit more prudent because they, um, they don't want to have what happened to SVB happen to them. And, um, each, each. Each bank, you know, has their amount that you can look it up, like how much they have for reserve requirements, how much they are lending out, how much, you know, yada, yada, yada.

And some banks are a lot stronger than others. Mm-hmm. Uh, the big banks are in, you know, they're in good shape. Um, SVB was just, was. Put it to the absolute max and then some. Yeah. Um, the other thing I was going to say, the Federal Reserve does is the, the F D I C, uh, insurance. And so, that's the two 50, um, you know, deposit insurance.

So, that way if the bank goes under the, the, you know, federal Reserve's basically saying, hey, we'll back that, uh, you know, account for up to $250,000 and so, um, 30 F D I C. Yeah, yeah, yeah, yeah. So, you know, that gives people more. Confidence in the banking system. I mean, imagine if you went in to go deposit your money and they're like, well, if we make it, we make it.

And if we don't, you're out of luck. You're going to say, oh, I'm not going to deposit a bunch of money with you. You know, you could go under and have no control over that, and I lose all my money. Um, but if they have the FTSE guarantee, at least there's a backstop where, um, you can limit some of those losses. And if you don't have over the threshold, you know, it's reasonable, um, uh, the reasonable assumption is if the bank goes under that, you'll be just fine.

You'll get your deposits back. Alright. A lot on banking. And I, I always encourage, and you do Glenn as well, to, um, subscribe to the podcast because you, you might want to listen back and catch something at what, wait, what was that? Yeah. And, uh, you've got a lot of episodes up there now. Mm-hmm. Um, look up intelligent investing on just about any podcast provider out there.

Yeah. Um, also, if you want to talk with Glenn, uh, always willing to have that conversation about your individual situation, you can call Glenn Leest at Intelligent or at WT Wealth Manage. Yeah, get my, my, my things mixed up here at 9 2 8 2 2 5 24 74. That's 9 2 8 2 2 5 24 74. Um, or, uh, the mail intelligent investing@wtwealthmanagthement.com.

So, next week let's get into the, um, federal Reserve. Yeah, we, we talked a lot about today. Yeah. So, I think the next logical step is talking about what they do. Yeah. Yeah. Probably some history there as well. Yeah. We should have a lot of stuff for you. Okay, everybody, have a great day. We'll see you soon.

The following has been paid programming brought to you by WT Wealth Management. Nothing we've discuss. Considered as investment advice. This conversation was for informational purposes only. Please do your own research and speak to an investment advisor or financial planner before making any investment decisions.