With the media attention that the continuing “Occupy Wall Street” protest have been getting, I thought it was fitting to talk about banks. Some of the more radical protesters have been calling for the elimination of banks altogether. One could easily see where these people are coming from. Banks do not create anything tangible. They make money by moving money around. They take your bank deposits, and loan it to someone to build a house (see the classic scene from “It’s a wonderful life” for a good explanation of that role). Why do they make such big profits, and could we do without them? Even among those of us who are more moderate, the size of the “bail outs” that the banks were given makes us uncomfortable. Aren’t we giving away our money to help save rich people from a mess they created?
First, why should we have banks. The job of a bank is to help allocate resources to their most productive use. In order to use our resources properly, it is necessary to sometimes put a lot of money down early to create something that will continually give benefits in the future. That is the definition of an investment. A house is a good example. While it cost a lot of money to build the house, once it is built it provides a lot of benefit and does so for a long time. Roads are another good example. What banks do, is they provide the people or businesses who want to make an investment the ability to do so – that is to say a loan. If you have a good job and you want a house, you do not need to live on the street for 30 years, and then buy one when you are 50. Instead, you can get a loan, buy your house, and pay the bank back the money gradually. That way you are able to live in the house for those 30 years, while paying for it.
However, the flip side to that is that everyone wants to have access to their money whenever they need it. When you take out a loan from the bank, your not actually taking the bank’s money. The bank is giving you money from your friends and neighbors that otherwise would be sitting in their account. If a particular friend needs money, the bank can provide it for them because it keeps some money on reserve. However, if everyone decided they wanted their money the bank would have a problem because you used their money to buy a house and have not yet paid the bank back. The bank would collapse.
Banks are important because they are able to serve the needs of the people who want the ability to access their money on demand (liquidity) and the people who want to make investments (houses, new products, etc). They are actually normally very good about figuring out what the best use of their loans are, because they do a lot of research about what investments will probably pay off, and which will not. That is why banks are important.
However, what happened leading up to 2008 is that the banks research was very wrong. The banks systematically underestimated the risk for some housing loans. This meant we built too many houses, and the market priced them much higher than they were worth. When people started to not be able to their loans, the experts started to doubt whether banks would have the money that you needed whenever you need it, or ever. This doubt started people running to get their money out of banks. The system was literally close to collapse – as in the last people to get to the bank would not have any money, banks would cease to exist, there would be no way to get a loan and therefore the economy would not invest and would basically collapse. That is why the government felt it necessary to insure that the banks had the funds to pay people.
An important thing to realize about the $700B “bail out” is that the banks were not given free money. The $700B was set aside to ensure that the banks could still function and was used in a couple of ways such as direct loans to banks (paid back with interest) or purchases of company stock. Money given to the banks will be paid back unless the bank collapses.