“You’re thinking of this place all wrong. As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house…right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others. Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can.”
George Bailey, It’s a Wonderful Life
It’s Sunday, I hope you have your broadsheet financial times folded on the breakfast table, glossy economist sitting nearby and mug of coffee/pint of orange juice ready.
People seem to be enjoying these banker blogs and thanks for the positive feedback. As I said the point is to take what can seem like complicated banking terms and break it into an easily readable paragraph or two. I have a passion for writing but also love the day job in banking, combing the two feels natural.
Having read the first two blogs, you will already have a better grasp of banking than the vast majority of people, now to look at another area.
Liquidity is a common topic when looking at banks but little or no time is spent explaining what it is (thus further fuels my fear that a lot of journalists don’t know what these terms mean and simply echo what they have heard).
What does liquidity mean?
Liquidity is how quickly something can be converted to cash. The money in your wallet has high liquidity, it is already money, you can use it right away. Your clothes, books, games have medium liquidity, you could probably sell them on amazon and get money fairly quickly but it won’t be instant. Your house has low liquidity, it could years to turn it into cash, you would have to contact housing agents, put it up on the market, sell it, conduct the missives etc.
If I need money and have liquidity, it is not an issue. The pipes burst in my flat, plumber charges £100, I have that in my wallet, no problem. If I don’t have that cash, I can sell a few things of medium liquidity and get the cash in decent enough time to pay the plumber. I am in trouble if all my money is in the house and plumber wants paid by the end of the week- no way I can sell the house by then. Low liquidity can be a problem.
How does this impact banking?
People use banks as a safe place to put their money. An incorrect assumption is that money is sitting in a vault somewhere.
Let’s say you put £1000 in the bank. The bank will use that money for various activities. The bank has calculated that you won’t want to withdraw all that money at the same time so it only keeps say £500 in reserve. It does this for everyone, people rolling up to withdraw everything is so rare that they feel comfortable only having half that money in the vault. To sweeten the deal for depositors, a bank pays interest from the money it makes on loans (that’s where your interest comes from, the bank loaning out money).
The bank uses the money to provide loans, mortgages and credit to other people, loaning out the money. These generally have every low liquidity as it can take years for people to pay them off, giving the bank the money back.
So why not have total liquidity?
Some of you might be worried about the idea that banks couldn’t give back all their customers all their money if they had to. Let’s say a bank does just sit with all the money, 100% liquidity, this would actually cause significant problems for society.
- How can banks stay in business?
So the bank takes £1000 from you and sits with £1000. Well the bank isn’t making any money off that. The bank will even be losing money if they still pay interest. How on earth can they stay in business? Simple answer is they can’t really and so they buckle and close. As horrible as the antics of some bankers were during the 2008 crash, if you want to see extreme corruption, look at countries that only have one, massive, state owned bank.
Some banks can charge fees for holding your money but even these banks need to invest and lend. For a bank to exist purely on account fees, with no lending, these fees would have to be eye wateringly high, unacceptable to most consumers.
- Goodbye fair loans for the rest of us?
Some brave banks decide to try and stay in business despite the demands for total liquidity. How could they do that in these extreme circumstances? The bank directors will use their own funds, not the depositors, to be used for loans. These handful of loans will either only be given to people who are sure bets (so a massive segment of the population lose access to easy finance like credit cards, loans, overdrafts etc) or alternatively with such extremely high fees and interest, it overrides the risk. Neither is very appealing.
A Bank Run
A Bank Run is when most the banks’ customers walk up and demand their money. As previously explained, the bank doesn’t have this, so they can’t. Like wildfire panic spreads, the banks’ low liquidity becomes a fatal flaw, more people join the queues to withdraw their life savings- which conversely makes the situation even worse. Think Northern Rock here in the UK.
Banks start to demand loans to be paid right away, they start foreclosing on houses where people were in difficulty, they do everything they can to get their hands on cash but it is a death spiral.
A run on a bank is one of the most awful events that can happen in banking, everyone suffers.
What to take away from this blog
Banks take money but it isn’t sitting gathering dust, they do things with it which is necessary to ensure the smooth operation of finance in general, from mortgages to loans to credit cards.