Banks, Leverage & All That

The reason why the Congress appeared more prudent to bail out the Detroit 3 (I believe they ultimately will, on both economic and political purposes) than the banks is this: the 3's products are cars, which money can buy, while the banks' product is money, per se.

How Bank Makes Money

This is a horribly-simplified version. Suppose you put down $2 million capital to open a bank. Taking $8 million deposit and lending out all $10 million, you got yourself a business model.

Your Balance Sheet reads (in $mil):

Asset	L/E
Loans $10	Deposits $8
	Equity $2

Now Suppose that you pay an annual 5% interest on deposits and collect 10% on Loans, on an operating cost of say $0.2 million (retail spots, headcounts, check clearances, ATMs, call centers, online banking), you make (10*10% - 8*5%) - 0.2 =$0.4 million per year, with a ROE of 20% on your capital.

Income Statement (Tax Free)

Interest Income	$10 mil*10%	$ 1 mil
Interest Exp	$ 8 mil*5%	$ 0.4 mil
Operating Cost		$ 0.2 mil
Net Income		$ 0.4 mil

"Terrific business!" You say. Indeed. And you can make it better by leveraging up more: if you increase the deposits to $18 million and loan out another $10 million, you make (20*10%-18*5%) - 0.2 = $0.9 million. ROE climbs to 45%.

Balance Sheet

Asset	L/E
Loans $20	Deposits $18
	Equity $2

Income Statement

Interest Income	$20 mil*10%	$ 2 mil
Interest Exp	$ 18 mil*5%	$ 0.9 mil
Operating Cost		$ 0.2 mil
Net Income		$ 0.9 mil

2 key money-making numbers here: the leverage (defined as assets/equity, in the latter case, 20/2=10) and interest spread (defined as loan rate-deposit rate = 10% - 5% = 5%).

But the leverage is a two-edge sword. In the first case, if you lose 10% loans, you are halved down to $1 mil. In the second, you're wiped out.

What May Go Wrong?

Forget about tax and operating cost, or even regulatory restrains, asset allocation, and funding (more on these topics later. as I said, it's an over-simplified demo), you have to face three major risks: namely credit risk, interest risk and bank run.

Credit Risk: You wouldn't expect collect all the loans. They go bad for various reasons.

Interest Risk: This one's tricky and comes from the term mismatch of deposit and loan. If you borrow at 5% for a 2-year deposit and lend out at 10% on a 10-year loan, and 2 years later when you wanna roll over the deposit but prevailing interest rate shoots up to 15%, you become 5% under. Sounds unbelievable, but it happened. More later..

Bank Run: Notice you lend all money out, so if a customer wanna withdraw some cash - say $1 mil - you have to sell assets to meet the call. It usually is not a problem, since you can leave some cash in the vault to take care of the daily flow. But it becomes a real problem when, for some reason, a large group of customers come all together - this is called a "bank run." If you couldn't secure additional funding, the only thing to do is to liquidate your assets, often times in a "fire sale." Rarely happening, it's kinda bad. More later..