Basic Economic Theory Moment

How a Bank Makes Money

The Fed raised the interest rate by a quarter percent recently and intends to do it again. This is what will happen over the next few weeks. Like any other company, a bank is in business to make a profit. The profit formula is:

Profit (π) = Total Revenue (TR) minus Total Cost (TC)
Where TR = Price (P) times (*) Quantity

Price is the interest rate banks charge customers.
Quantity is the number of persons that take loans.

The Total Cost to the bank is the amount borrowed and the interest
rate charged for their funds. The idea is to borrow money at a low rate
and loan it out at a higher rate. There are several sources of money supply to the Banks, but the biggest is the Federal Reserve System. Banks can also buy bonds and get customers to open bank accounts.

The Federal Reserve requires banks to open a reserve account (like
a checking account) and keep a certain amount of money (reserves) on
hand to cover the bank’s clearing checks and monetary transactions. The
amount is called the Reserve ratio. Banks generally keep most of their money in the Fed Regional Bank closest to them. When they loan money, they write a check off the Fed.

So how clever is a robber when they go into a bank? There’s not a lot of money there anyway, and they get the FBI after them. The average bank robbery is $4,000. The average sentence in Illinois is 6 to 30 years. If you decide to steal something, go after the armored car. If a bank puts $100,000 into the Fed and the reserve ratio is .2 (20%), they are required to keep $20,000 in the Fed, and the rest are called excess reserves that are available to be loaned.

The loans multiply the excess reserves. For example, Ryan borrows $100,000 from Midwest Bank to build a motorcycle shop in Lockport. He writes a check to Chris, the contractor, who deposits it in the Old National Bank, which puts money in its account at the Fed. The Regional Chicago Fed bank requires Old National to keep 20 percent in the bank, and Old National Bank has $80,000 in excess reserves to loan out. This process goes on for six to nine months with $500,000 of new money in the economy.

How did I know it was half a million? Simple, John Maynard Keynes, the Father of Modern Economics, stated the money multiplier was one divided by the reserve ratio. So, one divided by .2 is five. That means the original $100,000 will multiply five times. Notice the Fed can change the reserve ratio and increase or decrease the money supply. Lower reserve ratios lead to higher multipliers and vice versa.

The Fed models are so accurate that billions were injected into the banking system before the second tower fell on 9/11, which then multiplied to trillions. Bin Laden was meant to ruin the world’s financial
system and failed. The economy recovered in two weeks. Note several Lewis Graduates played critical roles in those two weeks to ensure the world financial system recovered. It is an exciting story for another moment.

You’re probably curious how the banks determine the interest rate
on a loan. The following formula shows how that works. I’ll use the
lowest COVID rate of .25% from the Fed)

Cost of Money (borrowing from Fed and saver deposits) 0.25% Plus: Administrative costs (tellers, loan officers, etc.) 2.00%
Plus: Profit 2.00%
Prime Rate (best customer who can repay in 24 hours) 4.25%
Risk factor to no Prime Customer (varies) 2.00%
Rate to you the less than Prime customer 7.00%

I’m out of words again (593). THE END.