Disruption in the Banking Paradigm

Things that might be done with "profits" are stranger than typically get imagined.

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Abstract

Perhaps the oldest “business model” is the classic dictum, “profit by buying low and selling high”. The banking industry is more about “renting” than “buying”, but the description “profit by obtaining at a low rate and offering at a high rate” is essentially the same business model. However, in the banking industry, unlike ordinary businesses, “profit” is the same “stuff” that gets handled in terms of “obtain” and “offer”. So, to the extent that profit is something “owned” and not “rented” by the banking industry, it is also something that can actually erode the relationship between banks and those from whom had previously been obtained the “stuff” of the banking industry.

Throughout History, wherever it happened that some folks became wealthier than others, businesses appeared in which some of that wealth became offered on a “for rent” basis –and while the exact rental-details have varied widely among those businesses as the centuries passed, generically all of them are known as “lenders”, and words such as “interest” or “usury” are typically used instead of “rent”.

While the first true “bank” was also a lender, it could be distinguished from all the others because of an additional feature: It was designed to allow almost anyone to work with the bank as a lender. The bank was willing to pay rent/interest on many quite-small-quantities of funds in order to consolidate those small quantities into a large quantity of lend-able funds –at a higher rental-rate/interest-rate, of course.

This gave the bank both an advantage and a disadvantage over its competition in the lending business. The disadvantage was the cost of the interest the bank paid on all those small quantities of funds; ordinary lenders did not have that expense. But ordinary lenders also had a fairly fixed limit on the total funds each could lend, since each one was using its own immediately-available wealth as the source of the funds it lent. A bank, however, was only limited by the total that had been deposited into it by all those small-quantity lenders. The more people the bank could entice (by paying interest) to lend it money, the more money it could lend out.

The net effect was, even if the bank had to take something of a loss in order to match the lending-interest-rate of its competition, after it had done that, and after the competition had lent all its available funds, then the bank became the “only game in town” that had funds to lend, and was free to charge a much higher interest rate on those funds.

History shows that the business model of the banking industry has been quite successful. As in any business, the difference between total income and total expenses is called “profit”, and as in most businesses, the profits of banks were mostly used to expand the business.

A few hundred years passed, and today the market is largely “saturated”. Banks are still basically profitable, but in most places all the potential lenders to banks, of small quantities of funds, are already doing that. So banks today mostly haven’t been constructing new facilities in new population centers with their profits; the stronger banks have instead mostly been buying the weaker ones out of business. This is called “consolidation”, and it is a well-known business practice, because the less competition any business has, the more it can charge for what it sells (or rents) –and the more profitable it becomes.

Consolidation is the first step in eroding the relationship between banks and those from whom they rent small quantities of funds. After all, each different bank can specify different interest rates; the higher the rate a bank offers to those with small quantities of funds, the more people will come along to lend them small quantities of funds. Obviously when fewer banks lead to reduced competition, the banks can arbitrarily choose to pay less interest –and increase their own profits thereby.

Next, consider what can happen after the consolidation phase is over (or stopped via anti-trust regulations), and the banks still have profits to use for something. For some banks, “shareholders” will demand that the profits be distributed as dividends. For other banks, there is nothing to stop them from lending those profits out, exactly as if this money had instead been an accumulation of small quantities upon-which interest was being paid. Except, of course, that profits are owned free-and-clear by the bank, and have no regular expenses associated with them. (Well, profits tend to be taxed, but only once per Taxing Authority. The after-tax profit the business gets to keep.)

Let us now examine some made-up numbers to begin the process of illustrating the remaining erosion of the relationship between banks and those from whom they rent small quantities of funds. We can ignore inflation, and whether the bank is small or large makes no essential difference –so we will make up figures for a rather small bank.

Suppose that a total of $1 million is deposited in small quantities. The bank is not allowed to lend all of it out; it is required to “reserve” some of it (often about 25%) to ensure that, if a bunch of people suddenly show up wanting their money back, they can get it back. So, right away we can see that this bank must pay interest on $1/4 million, without being able to lend it out to earn a profit.

Immediately we can also see that if some bank decides to save up its profits, it could use them to replace the mandatory “reserve” amount. Sure, if that was done, the saved-up profits would not be earning any money for the bank –but they would not be costing the bank anything, either. Why, the bank might even decide to save up its profits until, effectively, 100% of deposits are “reserved”, and the bank becomes completely protected from the absolute-worst-case-scenario of a “run” on the bank, by every single one of its depositors….

So now 100% of deposits can safely be lent out to generate more profit, in an environment where the overall population is still saturated with banking opportunities. What should these profits be used for? Here is where we should remember that the bank is a “lender”, and is competing with non-bank lenders. While it was previously mentioned that a bank likely needed to be able to match the loan-magnitude-and-interest-rate combination offered by non-bank lenders, we are now talking about profits possessed by the bank which exist after that matching has been done.

Some more made-up numbers are now appropriate. Suppose our small bank has three lender-only competitors, each of which can offer $1/10 million to a potential borrower. So, to match the terms offered by those lenders, our small bank must be prepared to offer 3/10 of its total $1 million deposits at a competitive interest rate. Only 7/10 can be offered at a higher rate, after the other lenders are out of money-to-lend.

Well, why not save up the profits to “take the place” of that $3/10 million? In the end, the net effect is that 100% of all deposits can be lent out at the highest interest rate that the market can bear (perhaps in the somewhat-special-case credit-card market), making even more profits, of course. What now?

Remember that “profits” can be defined as “money that isn’t actually needed for anything that is part of the normal operations of a business”. Profits could in-theory be converted into paper money and be literally burned, and the “loss” wouldn’t actually hurt the business one whit. Therefore, logically, the bank we’ve been describing can now use those profits to afford to begin to make loans that undercut its competitors. If one of these loans goes bad, the bank isn’t actually hurt –and there still exist various items of “legal recourse” that might eventually recover part of the bad loan.

Our small bank has now acquired the power to begin to put its competitors out of business. Monopolies are often legal if they begin to exist as a result of ethical business decisions –and there is absolutely nothing unethical about a bank saving-up its own profits. So, when it can begin to convert profits into ordinary loans that have unusually low interest rates –and especially as long as this bank can continue to pump profits into making more of those low-interest loans– other lenders in the region that charge more will lose lending opportunities.

The Law of Supply and Demand rules. While the price of a loan, the interest rate, often depends largely on the economic situation of the borrower, it also depends partly on the Supply of money offered for lending. That’s why it was stated earlier that when non-bank lenders have “lent their all”, banks can bring extra money to the table, and charge a premium for it. Now something of a reversal of the situation is being examined, where the bank may be able to increase the Supply even before the other lenders have run out of money to lend.

The bank needs to be careful not to interfere with its own profit-sources, which is why the special-case credit-card market was mentioned above. A credit card is a “write your own unsupervised loan” opportunity, with a pretty high interest rate used to discourage excess borrowing. (Nevertheless, large numbers of people have proved willing to borrow significant amounts at that rate.) More traditional loans, such as for home mortgages or business start-ups, are the arena of competition now being examined.

In general, there are limits to which Demand can be increased, just by offering a lower-priced Supply. For example, if brand-new automobiles were suddenly available for $10 each, how many would the average person want to own –when each one takes up significant space and is associated with things like “insurance” and “property tax”? Thus it should be deduce-able that the number of mortgage-class ordinary loans that can be made in a given region, even at low interest, is probably limited, also.

The preceding means that it is theoretically possible to “corner the loan market” in the region serviced by our small bank. If the bank has the money to lend, and the price is attractive, then virtually all borrowers will prefer to go to that lender instead of one of its competitors. And keep in mind that (A), the source of this money-to-lend is a pile of saved-up cost-free profit, and (B), even at low interest rates, these loans will generate profits, too!

So, the incomes of lending-competitors will go down while their expenses continue to exist. Even if one of the competitors happens to be another bank, well, as long as that other bank hasn’t saved-up its profits as described for this bank, that other bank is vulnerable to below-normal interest rates on traditional loans. And it still has to pay interest on its deposits, after all!

Once the competitors have gone out of business, of course, the bank could stop offering those low-interest loans –except for two things. First is that doing so opens the door for some competitor bank to spring back into existence, after which, and Second, the anti-trust regulators will start talking about “unethical behavior”, and say things like, “Hey, you were able to stay in business and even make profits offering low-interest loans. There is no reason why you can’t continue to do that!” Logically, the regulators are entirely Correct. Look above at the places where it was asked what-to-do with profits, and now think about answering that question yet again, especially if interest rates are raised to create even more profits. What does the bank really gain by doing that?

While none of the preceding things, regarding “reserves” and “competition”, directly hurts the relationship between a bank and its depositors, the suggested ways of using profit prepares the way for dissolution of the relationship. That’s because the above descriptions have almost reached the point where the bank no longer needs its depositors, and it can increase its profits by dumping them. It has cornered the lending market to the extent that no competitor could arise, and 100% of its deposits have been “covered” by a “reserve” consisting of piled-up profits –while an equal amount was being lent out for such things as credit-card-borrowings. So the bank could announce it is becoming a lending-only institution, request all its depositors to take their money out, and go merrily on its way, generating profits that, at last, become dividends for its shareholders.

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