How do banks invest money deposited with them by customers? Let us count the ways. They are legion. The starting point is that unless they are monstrously mismanaged, as we have seen they can be, banks almost cannot lose.
The bulk of non-wholesale funding comes from the general public. Customers deposit money in these near zero interest rate days not to invest money but to have the bank safekeep money. Banks invest much of the money short-, medium- and long-term.
Only around 10% might be held in cash or near cash (balances with other banks, the Bank of England and other central banks and government paper such as treasury bills and gilt-edged securities). Their counterparts in other countries will follow a similar pattern.
Inching along the spectrum
Broadly speaking, trouble will become more likely the further along the risk/reward spectrum a bank is tempted to go. Taking too much risk for too little reward, can be dangerous. Arguably even more dangerous is mismatching assets and liabilities.
The combination of both at Northern Rock a decade ago is an object lesson in what can go wrong. At its starkest, Northern Rock was extending 125% mortgages financed by current and instant access deposit accounts.
They also raised money in the short-term wholesale money markets which suddenly dried up. This is banking insanity. No sober person would even think of refinancing a mortgage every three to six months.
But it is nowhere near as insane as financing a stable of thoroughbred racehorses as at least one New York-based European bank did in the 1970s. How might the Basel Committee on Banking Supervision rank that today as a risk-weighted asset?
How does Barclays invest money?
The Barclays balance sheet for 2016 shows cash and balances at central banks as £102,353m out of total assets of £1,213,126m. Loans and advances to customers total £392,784m. Loans and advances to banks stand at £43,251m.
Other ways it chooses to invest money include secured lending, trading portfolio assets and assets classified as held for sale. The biggest item after loans and advances to customers is derivative financial instruments, totalling £346,626m.
Total equity, that is shareholder capital, is just £71,365m. This supports a balance sheet of £1,213,126m. Equity, shareholder capital at risk, thus amounts to less than 6% of the balance sheet total. This should send a shiver down the spine. This is far too little capital.
Don't believe the interest rate lie
In these straitened times, banks never tire of playing the sympathy card. They say that in a time of such low interest rates it is difficult for them to make money. They say this is because they cannot charge high interest rates. This is simply not true.
They cannot charge interest rates that are as high as they were accustomed to throughout the 1970s, 1980s and 1990s. Mortgage rates of 15% or higher were not uncommon in those days. Fixed rates were virtually unknown leaving borrowers vulnerable when inflation raged.
Such ruinous rates compare unfavourably with achievable rates below 2% today. But one of the first things that banks do when they hit trouble is to fatten margins. Almost irrespective of absolute rates, they can push up relative returns.
Interest rates double what you see
An interest rate of 2% on a reducing balance is nearer 4% on an annual percentage rate (APR) basis. Always check the APR. The same interest is charged throughout the loan even though the balance is steadily reducing.
This is a healthy margin for a basic product which is being funded almost for free. A car loan bearing a headline rate of 4% and subject to scheduled repayment spread evenly over the term of the agreement is really an APR of around 8%.
Add in documentation fees and application fees (sometimes non-refundable) and the revenue and profit numbers start to rise quickly. Investing money that is free or as near to free as makes no difference, at profitable rates, is like picking money up from the street.
There are also
- House loans (ie mortgages)
- Home improvement loans
- Loans to you to help your children to buy a home
- Loans to your children to help them buy a home
- Loans to furnish said home and your own home.
All will likely carry fees of one kind or another, the proceeds of which boost returns greatly. Then we have account fees. Lloyds Bank charges a monthly current account fee for retail customers. This does come with useful additional services.
There are fees for overdrafts (especially if unauthorised) on top of the interest charged on overdrafts. Fees are charged to arrange overdrafts even if the overdraft is never used. And overdraft utilisation fees are charged if a customer paying these fees goes overdrawn.
Barclays overdraft fees
- Up to £15 no fee
- Up to £1,000 75 pence a day
- Over £1,000 and up to £2,000 £1.50 a day
- Over £2,000 £3 a day
Returning to loans
Returning to loans, we have early repayment fees, late repayment fees, missed payment fees and the imposition of additional interest charges on the rapidly rising negative balance. Charges for letters sent advising the customer that the customer is overdrawn.
Once upon a time this was justified by saying the manager's time had to be paid for. Most often the only contact the manager would have had with the letter was the signing of it. And even that small point of contact eventually vanished with automation of the process.
Credit card rates are another outrage. Anyone using them as a form of borrowing rather than as a convenient payment method might care to consult a payday lender instead, as a recent high-profile newspaper article suggested.
Credit cards eye-watering
The annual percentage rate for credit card borrowing is in polite circles often described as eye-watering. The John Lewis Partnership card annual rate (APR) is 16.9% and it is one of the least usurious. For cash advances it is 23.9% as interest is charged from date of borrowing.
And remember, this is being financed virtually free by money from bank depositors. Plus there is a cash fee of 2.5% of the cash advance or cash-related payment, minimum charge £2.50. There is a £10 charge for a data protection act query.
There is a non-sterling transaction fee of 2.75% of the sterling value of the transaction. This is on top of the charge there will be for buying the foreign currency involved through the buy/sell spread. This can be grotesquely wide for retail buyers; say 18 US cents per pound.
Default fees on the JLP card include
- a £12 fee for paying late
- a £12 fee for exceeding credit limits
- a £12 fee for payments returned unpaid
Even the most casual reader will surely begin to appreciate the sheer scale of money that banks can make.
Lloyds Bank business credit card charges
- Late payment fee £12
- Limit exceeded fee £12
- Returned payment fee £12
- Annual card fee £32
- Cash withdrawal fee 2.5% handling fee, minimum £2.50
- Copy of statement fee £6
- Copy of transaction receipts £5 per item
- Non-sterling transaction fee 2.95% of the sterling amount
Other moneyspinners include
- Home insurance
- Second home insurance
- Life insurance
- Travel insurance
- Business insurance
- Key man insurance
- Home emergency cover
- Legal expenses cover
- Gadget cover
- Bike cover
- Sports equipment cover
- Critical illness cover
Insurance a side-effect
Selling insurance was one of the side-effects of increased automation in banking. Bancassurance, as it became known, began tentatively in the early 1980s to keep occupied staff whose jobs had been elbowed aside by cash machines and SWIFT terminals.
The idea was that these staff, mainly those who had left school at the age of 16 with little in the way of formal academic achievement, could sell insurance and investment products. Untrained, unskilled and often unable to understand customer needs.
It didn't really work. Fast forward to the 21st century and untold billions of pounds repaid for mis-sold personal pensions and payment protection insurance fees that had in effect been stolen from unsuspecting customers.
Hence the waves of new regulation over the past decade to protect customers.
A parliament of hungry barn owls
Let us conclude with a word of warning. If your bank contacts you out of the blue and suggests that you make an appointment to discuss your affairs, go prepared. They will try to sell you something that in all likelihood you simply do not need. Most likely insurance.
At a recent bird of prey demonstration, the audience oohed and aahed when the barn owl began cutely reminding the falconer that it was lunchtime. “Don't you fall for it,” the falconer told the audience. “He is a cold-blooded murderer.”
Similarly, bank customers would do well not to fall for the violin music emanating from banks struggling so hard to make a living in a low interest rate environment. They are the financial world's equivalent of a parliament of hungry barn owls out on the hunt.