Join Jim Stice for an in-depth discussion in this video Traditional banks, part of Finance Foundations: Fundamentals.
- Let's again think of the worldwide economic environment as a great sea, with three types of players swimming in the sea. There are the entrepreneurs, the doers, the creators. They've got business ideas, but they don't have money. We've also got investors swimming around out there, who've got money, from their savings in the past, and they can provide it to these entrepreneurs, so the entrepreneurs can turn their dreams into reality. But sometimes it's difficult for the entrepreneurs to find the investors, so they need facilitators, financial institutions, specialized institutions, that can match up entrepreneurs with investors.
It's inefficient, and sometimes not possible, for entrepreneurs and investors to hook up directly, they need facilitators. That's the role of financial institutions. A financial institution is just an intermediary. Now, if we were all infinitely sophisticated, and had infinite time, if I had a business idea, I could then go out and find the saver, the investor, who would provide the capital for that business idea. But I don't have infinite time, so if I'm new business owner with a new idea, I don't know where to go to find capital. I need an intermediary who's gonna put me together with an investor.
What kind of financial institutions? Well, there are lots of kinds out there, but let's talk about some major ones. There are banks, there are investments banks, which are an interesting entity, there are insurance companies, there are investment funds. Let's talk about each one of these financial institutions. We'll start with a traditional bank. A traditional bank is a very interesting financial institution. Again, it provides that classic role of putting together entrepreneurs with investors/savers.
The job of a traditional bank is to collect money from you and me, depositors, hold that money, and scan the horizon for potential entrepreneurs who wanna use that money to start new businesses. So, how does a traditional bank make money? Well, you look at your bank account. What kind of interest rate are you earning on your savings account? These days, this is 2014, you're earning less than one percent. In fact, at my local bank, in my hometown of Provo Utah, a rate paid to depositors right now is 0.10 percent.
That's what they're paying me when I deposit money into the bank. What are they charging to business owners who come into the bank and want to borrow money? Well, a little bit over five percent, 5.84 percent. So, how does a traditional bank make money? It borrows money from me and you, the depositors, and lends it out at higher rates to entrepreneurs. The traditional bank serves the role of a facilitator, a financial facilitator, taking money from you and me, the savers, and putting it in the hands of the entrepreneurs.
Another way to view a traditional bank is by looking at its primary asset and its primary liability. The primary asset of a traditional bank is loans receivable, the amount that the bank expects to collect in the future from the commercial borrowers who have come to the bank. The primary liability of a traditional bank, the primary source of financing of a traditional bank, is you and me, the depositors. The traditional bank gets money from you and me, the depositors, and loans it out in the form of loans receivable to commercial borrowers.
Now, my local bank, Zions Bank, is a traditional bank. The large majority of Zions Bank assets is in the form of loans receivable. The vast majority of financing for Zions Bank comes from the depositors. So, it's a classic bank, borrow from the depositors, lend to the commercial borrowers. An interesting trend in the last ten years around the world is that banks that have been traditional banks are expanding their operations, and we can see that with just some numbers from Citibank, a large money center bank.
First, you can see, it's much larger than Zions Bank, but take a look at the primary asset of Citibank. It's not loans receivable anymore. It has a lot of loans receivable, but Citibank also has a lot of investments in some very interesting things. Derivatives, and collateralized debt obligations, and mortgage-backed securities. Some very sophisticated investments that are invested in through very sophisticated processes. Citibank, its assets have gone beyond the assets of a traditional bank, just the loans receivable.
And where does Citibank get its money? Well, it gets some, about half, from depositors, but Citibank also goes out like regular companies and gets a lot of its financing just by issuing bonds, borrowing money from bondholders. Citibank, we can see just by these numbers has moved a little bit away from being a traditional bank. No longer is its primary asset loans receivable. No longer is its vast majority of its financing come from depositors. It's moved outside the realm of a traditional bank. Another important aspect of the banking business is bad debts.
When you loan money to businesses out there, you know you're not gonna collect it all. So, the happy task in a bank, every bank, at the end of each year, is to sit down, and say, "Okay, this year, how much did "we lose in terms of bad debts? "How many of our loans went bad this year?" And it's an estimation process, and not a very happy one. You see the numbers here for Wells Fargo Bank, a very large bank in the United States. Notice the interesting pattern. In 2008 and 2009, bad debts shot up.
Why would that be? Well, it's because the global worldwide recession, and that was reflected in the fact that many, many more of the companies that had borrowed money from Wells Fargo Bank, it was determined they wouldn't be able to repay. You can see that reflected right here in Wells Fargo's numbers. And even after the global financial crisis has calmed down, you see that, still, bad debts at Wells Fargo, in 2011, 2012, are still not back to the level they were before the global financial crisis, still reflecting the overall unsettledness of the worldwide economy.
You don't need to read the news, or the Wall Street Journal, or anything else, to understand the worldwide economy, just look at the bad debts of a bank.
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- Obtaining short-term and long-term financing
- Understanding the stock and bond markets
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- Working with financial institutions
- Using capital budgeting
- Creating simple personal saving and investment plans