How Banks Make Money and How You Can Do It Too

In my previous life, I spent around a decade of my life analysing banks.

In essence, a bank makes money by getting money from someone at a lower rate (deposit) and lending it out to someone at a higher rate (loan).

The profit drivers are therefore, 1) volume and 2) the spread between the two rates mentioned.

The tricky part is that the deposit is pretty much guaranteed so the bank has to repay back while the loan is not. This is where the risk management comes in. (But actually what brings the bank down is not credit but something else, which we will discuss more in a future post.)

Another thing is the bank gears up. This is the most important concept – OPM (or Other People’s Money). For every dollar of capital, it may have multiple dollars of assets. The constraint is the capital ratios determined by the regulator.

To illustrate, imagine you have $100. If you invest that $100 in an asset that returns 10% per annum, in a year, you would have $110.

Now imagine, if you have $100 but you borrow another $100 from your friend or the bank. Your friend or bank charges you 5% per annum. You invest the $200 in the 10% returning asset such that after a year, you have $220. You pay back your friend or the bank the principle of $100 plus the $5 interest and get left with $115.

With that one extra step, you have just made 50% more in return. Now imagine if you can borrow more than $100 from your friend or bank…

When it comes to personal finances, I think there is too much focus on the asset side, there should be more discussion on the liabilities side. That is, how much you can borrow based on your credibility. Most of us are not optimising our personal balance sheet.

Typically, our biggest borrowing is our mortgage and if you have bought a house in the last 10 years, you would have ride the asset appreciation cycle and made a killing.

However, that was a big call made right. The result could have been disastrous otherwise.

To me, investing is more about consistently making returns knowing that you can only be right at best probably 60% of the time so the other skills are to time and size your bets accordingly.

Other than mortgage, which is borrowing against your property, you can also borrow against your income or other assets like stocks or bonds.  

Assuming you have a stable source of income, you can ask the bank to give you a credit line on that and use that money to invest in assets that generate a higher yield than the bank charging you.

Typically, the bank may lend to you at say around 2% and you invest at some bond or bond ETFs (if your lump sum is smaller or want to be more diversified) that return around 6%. Then you make a 4% spread. The caveat of course is whether this is the right thing to do in a rising rate environment but that is beyond the discussion of this article.

Other than bonds, you may also consider high dividend stocks or ETFs but their prices maybe more volatile. The problem with that is cash flow matching. Unless it is a rolling loan, that is, there is no need for repayment of principal, otherwise, volatile asset prices mean higher risks as there is a possibility of selling your asset at a lower price to repay the loans. Managing cash flows is important when it comes to personal lending and investments, you cannot just focus on returns.

In terms of assets, there are also leveraged insurance products, which is where you pay $100 in premium, a bank may lend you another $100 as part of the insurance package and invest that $200 into an asset.

As can been from the above arithmetic, if you do this long enough, the returns or the proceeds you could get from this leverage product at the end could be much more than a non-leverage product. However, as with all insurance products, you should look out for all the hidden fees.

Finally and most importantly, to do all these investments requires a mentality. The mindsets of being comfortable with managing large sums of money as well as keep investing when you have lost money.

This is because remember, you are probably at best right 60% of the time so when the other 40% hit, you need to have faith and grind through, otherwise you will stay at that 40% forever and for most people, that is where they stay.

I believe mindset is the single most under-stated factor in investment.

On the flip side, having being an analyst myself, I would also say analysis is over-rated. Without the right mindset, no analysis in the world can help you prepare for losing money, which is the most devastating and demotivating feeling, the pain of which, depend on how much you lost.

I recall reading the book Stress Test about the financial crisis and the author mentioned even they had all the data provided to them, they couldn’t foresee the coming crisis and these were very smart people.

So instead of spending all the time doing analysis, start actually investing once you are comfortable with what you are doing and see if you actually have the mindset of an investor, which not many people actually do.

Disclaimer: This article is not meant to be investment advice but personal opinions and thought for discussions. 

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Categories:investing

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