What do banks invest in?

What do banks invest in? How much do they “skim off the top” before they hand out interest to their account holders?

Classically, banks invest in loans. They borrow money from depositors, paying them x% interest, and lend it out to borrowers, charging them y% interest. The spread, y%-x%, is the bank’s return.

Of course, it gets more complex than that. The amount lent out doesn’t exactly equate to the amount deposited. The bank pays different interest rates to different depositors, and charges different interest rates to different borrowers. Many banks also have an investment management arm which invests and manages customers money for a fee. And so forth.

Well, basically they invest in loans e.g. personal consumer loans, home mortgages, funding for small, medium and large corporates. A major profit source is the differential between the interest rate they pay to their depositors and the interest rate they charge to those who borrow money. This interest rate margin will depend on:

  • the nature of the product;
  • the competitiveness of the market;
  • the degree to which the market is regulated;
  • consumer protection requirements etc

Don’t forget funding for The Gummint. (Bonds.)

You’re acting as if the money’s here, but it’s in Jim’s house, and Dave’s house…

Okay, that technically wasn’t a bank, but so what?

There’s all different levels of banking, there’s the mom and pop bank on the corner, then there’s State Street Bank in Boston. Big banks generally invest large sums in low risk investments, they don’t need to take big risks because they have large sums of money, one tenth of one percent of a billion is million bucks. But they do some exotic things too, like buy futures in foreign currencies to hedge on their overseas investments. Almost all banks are big into real estate investment, just look for the tallest buildings in the biggest cities, they are generally banks (or insurance companies, which are basically banks in a different suit of clothes).

How prevalent are mom-and-pop banks?

I ask because banks really need to seem secure and stable and absolutely immune to the whims and wiles of day-to-day life. Large corporations are seen as all of those things, while smaller operations are generally regarded as being fly-by-night and, ultimately, transient. That seems like a pretty hard thing to overcome if you’re trying to establish a new bank in any economy.

So, does anyone record the number of single-branch banks?

Not sure how many there are, but $100,000/account deposit insurance from the Federal Deposit Insurance Corporation should alleviate the average person’s fear of their bank going under.

Banks invest in everything.

For ordinary commercial banking, they don’t “skim off the top” from their investors. Basically it works something like this:

Blalron takes $1000 and deposits it in a savings account at, say, Bank of NY. BNY is required by the Federal Reserve to keep a % of their deposits on hand (called a reserve ratio). So lets say the reserve ratio is %5. BNY can take your $1000 and loan out $950 of it to other people. They make money off the interest on those loans as well as fees they charge you for various services.

Investment banks deal with institutions. For example, Goldman Sachs or Merrill Lynch might put together a merger and acquisition deal between two companies or help a company go public with an IPO. For this service, they will keep a percentage of the money made on the deal. They also trade in various financial instruments - stocks, bonds, currency, derivatives, what have you. Much like a stockbroker, they collect a commission off of these transactions.
As for the actual %, that I don’t know.

Yep, including stocks, bonds, T-Bills, real estate, etc. - banks invest in everything an individual invests in and a few other things, too, like overnight funds.

All correct, but it’s really much more complicated. Let’s say the bank only had loan demand for $500 that day. That leaves them with $450 in “dead” funds. In order to get some return on that money the bank will likely invest it in “overnight funds”. This is a pool of money that is loaned overnight to other banks to balance their books. For instance, Bank “A” has $450 more in deposits than loan demand. Bank “B” took in $1000 in deposits (net $950 after the reserve requirement is met) but loaned out $1400. Bank “B” will borrow $450, at the prevailing bank-to-bank interest rate, in overnight funds. Bank “A” gets one day worth of interest on their $450. Bank “B” has to pay overnight interest, but that’s less than the loan spread so they still make money, and they balance their books. The next day the scenario repeats, but it may be Bank “B” contributing overnight funds and Bank “A” borrowing.

When the bank has significantly more funds on deposit than outstanding loans, and the imbalance is projected to remain that way, they will invest funds in longer term, higher yield investments.

It’s a very delicate, multi-trillion dollar, nationwide daily balancing act.