Wednesday, February 19, 2014

How banks make their money and why we should learn from them?

When we play the game monopoly, we know that the bank is rich and everyone pays to the bank when they buy a deed of land. In our real world, we know that banks are rich as almost everyone deposits money in the bank. So how do banks make money?  Banks lend out money and earn from the interest. This is the primary business of a bank.

The business of the bank

Banks do the same thing over and over again. Take the money they have, lend it out with interest, get back the money with interest and lend it out with interest again. This creates a consistent cash flow for them. Of course banks do other things with the money the have for example investing it in bonds etc. But come to think of it, isn't investing in bonds lending out money with interest too?

How we can be like the bank?

Lending out is a good business. We can also be like the bank and create consistent cash flows for ourselves. Take the money we have, lend it out with interest, get back the money with interest and lend it out with interest again. So who do we lend it to? The answer is we can lend it out to the financial markets.

The financial market is created to facilitate the transactions between lenders and borrowers. With the financial market, borrowers can seek funding from lenders and lenders can lend out money to borrowers in a fast and efficient manner. The stock market and the bond market are part of the financial market.

In the bond market, corporations or the government can borrow money through the issuing of bonds. When we buy a bond, we are lending money to the corporation or government who issued the bond. By lending money to them through bonds, we are paid interest for it. We become like the bank who lend money out to others. However, before investing in bonds, you should know how it works and how interest is paid out etc. Read: 4 things you should know before investing into bonds

In the stock market, companies who need more money to expand their business can seek for people to invest in their companies. When we invest in a company through the stock market, we effectively own a part of the company. This is even better than lending out money only. Owning a part of the company entitles you to dividends that the company pays. This is like the company paying you a share of their profits. As the company earns more money, dividends are expected to increase. Of course sometimes it does not increase and that's where we have to look out for.

How to choose who to lend out to?

Choosing who we lend our money to is important. Choose the wrong person and you may lose all your money. We can learn from the bank on how to choose the correct person to lend out to.

Banks do a detailed report of a person before deciding if they will lend to an individual. Some deciding factors are:

  1. Does the person have a stable income and how much income?
  2. Does he have many other outstanding loans?
  3. Is that person over leveraged on debt?
  4. Does he have any assets?
  5. Does he have any prior bad financial report ie. failure to repay loans or bankruptcy
I'm sure there are other factors but well i hope you get a rough idea. Using the above profile, we can do a detailed profile of the company we want to invest in too. Some factors to look out for in a company are:

  1. How much profit does the company have and is it consistent?
  2. Does the company have huge debt? Is it manageable?
  3. Does the company have any assets?
  4. Does the company allocate capital efficiently?
These are just some simple factors to consider. This is not enough when evaluating a company as companies are more complicated than individual persons. I have written a series of post on how to pick stocks. You can read it up to learn more here

A risk to take note

Banks have collapsed before and the most famous one is Lehman Brothers which collapsed during the 2007/08 global financial crisis. Why did it fall? The answer is that it was over leveraged. To say it simply, it actually lend out more money than it had. Reports say that Lehman Brothers has a leverage ratio of 44:1. This means that every $44 it lend out, only $1 was from its own pocket. 

When we invest, do not invest using money which you do not have. Using borrowed money to invest is dangerous. In stricter sense, do not even invest money which you will need for paying bills or for emergency. 

By learning from the bank, we can be like the bank. Use the money we have, lend it out or invest it with interest or dividend yield, get back the money with interest and dividends then lend it out or invest it again. Repeat the process correctly and you will become rich one day. We may not have people depositing money with us but we can deposit money into ourselves. This is the art of savings. Using this money we deposited into ourselves, lend it out or invest it. Put it in the correct place and see it grow. However, put it in the wrong place and it will wither away.

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Related Posts:
1. Buying the company on the streets (Part 1) - Discovery stage
2. Investing is like water that flows out
3. How to pick stocks (Part 2) - The profitability of a business

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