BANKS ARE THE CORNERSTONE OF THE U.S. economy. First formed in 1775 by Ben Franklin, they are an essential part of the economy because with them businesses can flourish, employ people, lend money for mortgages and build communities. Banks can be saviors or hindrances, but they are always the place we go when we want money.
What you have to first realize about banks is that they are in the business of selling money. Well, that is not entirely true; banks are in the business of selling interest rates on money. Car dealers sell cars, clothing stores sell clothes and banks sell interest rates. Not a bad business to be in, since money is the sole commodity that fuels any modern economy. A bank will sell you money at a predetermined rate known as an interest rate. They will lend you a principal amount and then expect you to pay them back a predetermined amount over a set period of time. But how do banks get money to lend for mortgages?
Banks are the only institution in the world that can take the commodity they are borrowing and lend it out five, six, or seven times over. Could you imagine a car dealer borrower a car from someone, cutting it up into 6 pieces and selling it for more then the original car? Of course not, but banks can do this with money and time.
Banks have the miraculous ability to borrow from their deposits and the governing bank known as the Federal Reserve, known as The Fed, then turn around and sell the money for a profit. But how can they do this? It is not how, but why they do this that matters. Banks can borrow money and lend it out based on risk. For example, if they lend out the money to a business, that business will employ people, and those people will be able to place that money back into the economy.
Where does the profit come from if a bank is borrowing money? If a bank is borrowing money from their deposits — such as certified deposits, or CD’s — that are giving a return to the deposit holder of 4.25 percent and lending it out at 6.25 percent, then they are making a profit of 2 percent. Obviously there are other costs involved, but if you were to take that example and multiply it by 10,000, you would begin to see how profitable lending out money can be.
Without banks, the nation’s economy or any capitalistic economy could not survive. Our economy is based on one “I owe you” to another. For example, if you were purchasing a house, you would borrow money from a bank, which in turn could borrow money from the Fed. Of course everyone is making a little more on everyone else, but in the end you get a house, the bank makes money on the money and so does the Fed. In theory it is an incredible system that is essential for our economy to thrive.
MIKE HEAYN is a Washington Mutual Multi- Family Loan Consultant. He 310-428-1342, or e-mailed at
Originally published in the Santa Monica Daily Press print edition on October 10, 2007. Read the original PDF.