r 
Three 
Bank operation made simple(r) 
 BANK AND THE REVENUE STREAMS that support it do not just spring into existence on day one. It takes effort to find 
deposits and effort to lend them out. Few banks open up with loan customers on the doorstep with good business ideas, or deposit customers strolling in the door looking for a place to deposit their money. Why do banks offer free toasters and tablets for new accounts? Because they need to. Why do banks offer teaser loan rates? Because they need to. 
r 	deposits 	Bank 		loans 	t 	
							
	/ 					
					Federal 		
	Another Bank 	I 	I 	Reserve 		
Fig"re 3.1: Don't be fooled. Diagrams like ihi« tell a story, but they only tell a tiny bit of it. Simplified boxes and arrows are easy to draw, but they call hide mIlch more than they reveal. 
This is all merely to say that if you're going to think about banking in a productive way, you can't just look at the block diagram, the circles and arrows that indicate the flow of money. There is a lot hiding under those arrows and mastering block di- 
41 
A

42 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
agrams and balance sheets isn't the same as understanding the issues bankers face each day. Managing the different types of risk, types of lending, and the relationship to other banks are all important parts of starting a bank and keeping it going. 
Bank income 
The varieties of ways banks generate money is staggering. Of course, the basics have only to do with the classic investment advice: buy low, sell high. Banks take money in at a low interest rate and lend it out at a higher rate, and that's a1l34 Pretty dull, right? Savings and loans were once known as the "3-6-3" business: take money in a 3%, loan it out at6%, be on the golf course by 3 o'clock. That's all changed, not necessarily for the better. 
Especially with the decline in interest rates over the past decade, banks increasingly have turned to fee income. This isn't just the kinds of fees like you pay on a checking account or on credit cards, though it certainly includes those. It's also fees on business like trust management, brokerage, bond issuances. 
Of course there is a chicken-and-egg effect here. Rates can be so low only because banks have all this fee income built into their business model. Banks can be profitable with almost zero interest rates, particularly when the Federal Reserve lets them borrow at those rates. In an earlier climate, banks would be begging the Fed for higher rates long before this point. Even now, though, smaller banks, who tend not to have the fee income of the larger ones, are suffering. 
Here's a short and incomplete list of the many ways banks make money besides interest rate arbitrage. 
Financial Advice Banks frequently offer financial advice to their customers, and charge for the privilege of receiving that advice. 
34This is also called interest rate arbitrage, a fancy word that just means taking advantage of a difference in price between two markets. A bank with a global reach can notice that some bond is selling for one price in London and for a lower price in Tokyo. If they can act quickly enough, they can buy in Tokyo and sell in London and make a bundle before the price difference disappears. This is bond price arbitrage. In almost the same way, interest rates are usually quite different in the market for loans and the market for deposits. 

BANK INCOME 
43 
Trust service A trust is an independent entity with some assets or an income stream to manage. The trust department of some bank might be available either to be the trustee or just to manage the assets under the oversight of some outside trustee. Lots of bond transactions will require a trust of some kind, perhaps to receive some income stream on behalf of the bond owners, or to oversee paying down some previously issued bond. 
Fund management Banks don't just give advice, they frequently manage investment funds, too. This is often in conjunction with some other service, like trust management, but by no means always. Fees are usually assessed as a percentage of the funds under management. 
Letters of credit For a fee, a bank will commonly offer its reputation, its credit rating, for a customer who needs to buy something on credit. The LaC assures the seller that payment will be forthcoming, so it's ok to ship. LaCs are also used in loan transactions to substitute the bank's credit rating for the (presumably not as good) borrower's credit rating. This allows the borrower to borrow at a lower rate. Unfortunately, LaCs have a term, which is usually much shorter than the bond term, which means they have to be renewed, at which time the bank has a certain amount of leverage over the borrower. 
Bond sales This is more of an investment bank function, but many big banks now have sister investment banks within the same holding company. A government or company that wants to issue bonds generally has them purchased by some bank for resale on the open market. This bank is the underwriter of a bond. The bank will build some profit into the transaction, sometimes in obvious ways, sometimes not. Banks are sometimes both the financial advisor to some city or town and the underwriter of its bonds. This is an obvious conflict of interest, but has been the order of the day for some time, since the wall between investment banks and commercial banks was punctured by the repeal of the GlassSteagall act in the 1990s. The Dodd-Frank legislation was supposed to have clarified this, but that bill remains a work in progress. 

44 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 

Sales of loans A bank makes a loan, and then it has an asset that produces income. At some future time, it might decide to sell that asset to someone else. This will give it more capital with which it can make more loans, or invest in some other way35 

Payment processing A bank charter is essentially permission to transform checks into money and the other way around. Lots of money market funds exist that are not part of some bank. These funds will need this kind of service, which is why the checks for a fund you might own typically don't have the fund company's name on them, but some bank's instead. 

Lockbox service A government, agency, or company that sends out bills and receives payments, can use a lockbox service to receive the funds. This is an address to which customers send their bill payments, and the bank facilitates turning those payments into account balances. 

Consumer fees Fee income from bank account customers has become increasingly important to banks. This includes the familiar account maintenance fees, ATM fees, overdraft fees, money transfer fees, and so on. Banks also charge merchants a fee when they take a debit card in a transaction.36 

Credit card processing A credit card customer is essentially a borrower and so pays interest on his or her balance, but even customers who payoff their balance each month are subject to a variety of fees: late fees, annual fees, over-the-limit fees, and more. The most notorious is the swipe fee, also called the interchange fee, charged to merchants who accept a card 

35 As will be bllndingly obvious to virtually anyone who reads this far; the sec' ondary market for loans is a big deal and is intimately related to the sad history of the 2007-08 financial crisis, but it's worth remembering that there are perfectly sound reasons both for selling loans and for constructing mortgage-backed bonds in order to do so. The fact that both of these were abused during the run-up to tl1\1 crisis in no way diminishes their utility as a vehicle for policy. 
36Reducing or eliminating those fees was supposed to be part of the Dodd Frank legislation to establish the Consumer Financial Protection Bureau, but thl\ rules that came out of the legislation weren't as effective, so customers currently pay an average of 24 cents per transaction while the cost to the banks is closer to '1 cents according to a 2013 report from the Fed. 

MANAGING BANK RISK 
45 
for payment. Swipe fees for credit cards earn banks over $30 billion each year, in the US alone." 
Restating value of assets Other traditional ways for a bank to "make" money involve fiddling with the accounting. For example, a bank can appear to make money by decreasing its loan loss reserve. This increases the value of the assets, which is compensated for by increasing the value of the retained profits on the other side of the balance sheet. And, of course, such profits don't have to be retained and can be distributed as dividends, or bonuses. Other ways to have the same effect involve getting real property re-appraised, changing the risk model, or simply claiming a higher value for the assets, perhaps because of market changes, or perhaps because someone in accounting was suborned. 
This is really only the beginning of the ways banks find to (Inrn income. Each of the categories above has sub-categories, and doubtless there are entire categories that have been overlooked. 
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Managing bank risk 
A bank's operation is all about taking risks and managing them,38 hili there are several different kinds of risk: credit risk, liquidity 1·INk, market risk, concentration risk, regulatory risk, operational riNk. And tornadoes. Considering the different kinds of risk will l"'lp make sense of the purpose behind the various regulatory raIl". and rules and also help refine your sense of what kinds of rllvities are wise for a bank to undertake. 

''IMcrchants in the US pay very high swipe fees compared to other countries, .n IWI~rnge of 2% of each transaction. In Great Britain, swipe fees are around 0.79% 11111hl,) European Union limits them to 0.3% of each transaction. In 2012, a $7.3 bil- 111111 "llttlcment was negotiated to settle a class-action antitrust suit that accused 
I." I1l1d MasterCard of collusion and price-fixing their swipe fees. As of this writ:IIK. the settlement is under attack by the merchants who call it inadequate, and if'. tlilt dear whether it will stand. 
"flopcfully small and manageable risks, but as we've seen, not always. The Ifh'h!tlCC between banks that go under and banks that do not is largely a matter , dll~I'l)C of risk, even if bankers will deny it. 

46 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
•	Credit risk is the most basic kind of bank risk. Give someone a loan, and they might not pay it back. The fear of this risk typically determines the interest rate a debt incurs. A risky debtor will only get a loan at a high rate. 
•	A bank's liquidity risk is the risk that it might not have enough cash on hand for customers who want their money back. Maybe it loaned too much out, or maybe too many loans went bad. A bank without plenty of cash on hand to serve its customers' needs has lots of liquidity risk. A run on a bank-when customers want money back that the bank doesn't currently have-is a liquidity crisis. 
•	A bank undertakes market risk when market conditions might change the value of some asset it owns. For example, if a bank holds $10 million in California state bonds, and the ratings agencies decide that California's credit rating is too high, the value of that asset might go down to $9 million. Another example would be that when real estate values drop, the value of the collateral a bank holds for its real estate lending falls. This will make the value of the loan itself fall. In both cases, the value of the bank's assets changed because of circumstances far beyond the bank's control, though obviously there was discretion involved in taking the risk in the first place.39 
•	Say you're a bank and took some deposits, promising to pay 1 % interest. You used the money to make some long-term loans paying 3%. A couple of years down the road, interest rates rise, and your customers demand higher interest rates than a measly 1 %. If you don't pay those higher rates, they'll withdraw their money and you'll have a liquidity crisis when you run out of cash. But if you pay your depositors 4%, then your cost of funds will be higher than what you're earning on your loans, and you'll lose money. Or maybe 
39The mother of all market risks was, of course, the phenomenal bets banks made on subprime mortgage backed securities in the run-up to the financial crisis of 2008. When subprime mortgages went sour in large numbers, the market for these bonds evaporated nearly overnight. Some of the nation's largest banks still have billions of dollars of these bonds on their books, with essentially zero market value. A special exception to the accounting rules was granted by the Fed to keep banks like Bank of America, JPMorgan Chase, and Citigroup from being declared insolvent. 
MANAGING BANK RISK 
47 
you bought a bunch of long-term Treasury securities as collateral, but then interest rates rise and the value of the collateral falls. In each case, your bank was overtaken by interest rate risk, a category of market risk that bankers often mention. Banks can be vulnerable to interest rate movements in either direction, depending on how it conducts its businest:\ The debacle of the Philadelphia interest-rate swaps was0 motivated by banks looking to offload interest-rate risk onto· the city government. 
•	A bank that loans to too few customers (or takes deposits from too few) suffers from concentration risk. If something goes bad for a single one of your customers, do you want to risk your bank? Some customers, such as governments, may not be risky, but advocates for one-customer banks must be prepared to say why not. 
•	Banks can suffer from regulatory risk, when rules and regulations change, sometime without warning40 
•	And operational risk is when something else goes wrong: software glitches, lost records, customers suing over deposit slip paper cuts, embezzlement and robbery+' executives jailed for wrongful foreclosures,4' and so on. Technically speaking, tornadoes would actually fall under operational risk. 
Different sets of customers and circumstances can present very different kinds of risks. Some customers have highly predictable 

48 
CHAfYfER 3. BANK OPERATION MADE SIMPLE(R) 
cash flows, for example. For these customers, liquidity risk is easy to manage, and so a bank's cash reserves can be lower. Remember, the regulatory minimum for reserves is just that, a minimum. Prudent management can, and often does, require higher reserves for certain classes of customers. Another bank might find itself lending to highly reliable customers, but with a very unpredictable source of funds. For example, it might be funding its lending operation by borrowing in the repo market. This bank has to tread carefully, because even though its credit customers are very reliable, the interest rate on its borrowing can change rapidly. 
A bank can, and should, be aware of the risks on its balance sheet, and ought to do whatever it can to minimize them. At some level, the risks are unavoidable, so the bank must insure itself against them, but for several kinds of risk, there are reasonable measures to take against them. Being alert to borrowers who may be in trouble is one obvious step to take, as is managing collateral to maximize its value. A bank can reduce its liquidity risk through analysis of its deposit customers in order to understand the ebb and flow of their deposits. A bank can reduce its market risk by spreading its investments around into a variety of different venues. 
The other way to manage risk, of course, is to find someone else to take it, wittingly or not. A great deal of life in America today can usefully be viewed as a struggle about who assumes risk. Who, for example, assumes the risk that an air traveler suffers a family emergency that prevents travel? Is the lost fare the traveler's problem, or the airline's? The airlines used to assume that risk, but not so much any more. Bus lines now sell reserved seats instead of open-ended tickets, reducing the risk of empty buses (or over-full ones), but increasing the risk to the traveler that he or she will not be able to use the ticket. Health insurers sell largedeductible policies where someone who gets ill can be liable for thousands of dollars in medical costs. Consumer products companies make customers pay for a warranty that once was considered a selling point. The consumer can gripe about having to assume risk that once was invisible, but risk is a real thing. If you wait long enough, any risk will cause a loss. Companies can only absorb so much risk before they can endure no more. The struggle, or negotiation if you prefer, is about determining where that line is between an acceptable sharing of risk and an unconscionable shirking of it. 
LENDING 
49 
These same motives push banks. Is an interest-rate swap like Philadelphia's a way to accommodate the differing needs of the two parties, or a way for a bank to foist interest-rate risk onto an unsuspecting customer? Is mortgage securitization the way IndyMac and Lehman Brothers (and so many others) do it a way to increase the pool of money available to a bank, or a way to foist credit risk onto bondholders? Is a CD a convenient way to get a higher interest rate or a way to get a bank's customers to assume some of its liquidity risk? 
Lending 
When banks lend, they look for liquidity, security, and yield. Like the joke about good, fast, and cheap, you can get generally get any two qualities out of three, but no more. Often, you have to make do with just one. 
For example, T-bills-very short-term loans to the US government-are very liqutd and very secure,43 but also have about the lowest yields around, measurable in units of hundredths of a percent (also called basis points). Or you could look for security and yield, and offer 3D-year mortgages, where the yield is higher, and security is decent (if you're careful with your lending standards), but they aren't nearly as liquid. Or you could opt for liquidity and yield=-certain "tranches" of mortgage-backed bonds (see "Subdividing bonds" on page 135) were quite liquid and quite profitable during the 2002-2006 period-but those investments were pretty risky, as the catastrophe of 2008 showed. 
A bank's loan portfolio has to balance all three of these qualities. It's not good enough to have a collection of really secure loans if the bank will suffer a liquidity crisis before they're paid back. Similarly, it's not much use to make only very liquid and secure investments if operating costs will sink the bank because its assets have such low yields. Because the world ultimately is not very predictable, a little humility is in order while making that design. A bank whose solvency depends on everything turning out just right won't convince the regulators (and maybe investors, or legislators) who need to be convinced. 
43Despite the efforts, near the time of this writing, by Republicans in the US House of Representatives to threaten default on those obligations. 

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CHAPTER 3. BANK OPERATION MADE SfMPLE(R) 
Lending theory 
It's well and good to put up balance sheets to talk about, but it's also worth looking at the process by which they change. Let's imagine the Bank of Sunnydale just about to make its first loan. You can see its balance sheet for its initial condition on page 22. 
Let's assume that before anyone shows up with money to deposit that a fine and credit-worthy customer named Henry is at the door on day one wanting to borrow a million dollars. Because Sunnydale's management is young and foolish and because it suits our pedagogical purpose to say so, Henry's loan application is approved instantly. Sunnydale management pays the loan by establishing an account for Henry, and their balance sheet now looks like this: 
Assets 
Liabilities & Capital 
$1 million loans 
$10 million building, artwork $5 million intangibles 
$30 million securities 
$5 million cash 
$1 million deposits 
$0 retained profits $30 million stock $20 million surplus 
$51 million 
$51 million 
Sunnydale has simply made up the money in Henry's account, and balances it with the asset represented by the pile of loan agreements Henry filled out in order to get the loan. Nothing else on the balance sheet changes. In a way there is something slightly magical about this-the bank has appeared to create money out of nothing-but what happens when Henry wants to spend his loan proceeds? 
Suppose Henry writes a check for $1 million and gives it to Sarah in exchange for a lovely mansion and estate in Sunnydale's suburbs. Sarah deposits the check in her bank who submits it for clearing and the result is a message that tells Sunnydale to transfer $1 million to Sarah's bank and to debit Henry's account for the funds. The money transferred could be cash, though it is more likely to be deposits in Sunnydale's account at some other bank, like the Fed. So they execute the transfer and now Sunnydale's balance sheet looks like this: 
LENDING 
51 
Assets 
Liabilities & Capital 
$1 million loans 
$10 million building, artwork $5 million intangibles 
$30 million securities 
$4 million cash 
$0 retained profits $30 million stock $20 million surplus 
$0 deposits 
$50 million 
$50 million 
The books stay balanced because we've deducted the same amount from the deposits as from the "cash" line of the assets. Later, as Henry pays back his loan, his payments will decrease the outstanding value of his loan, increase the "cash" line on the assets side of the sheet, and also increase the "retained profits" line in the capital with the part of his payments that represent the interest. 
This transfer of funds has changed Sunnydale's balance sheet, but not in a bad way. They still have enough reserves for what they need to do, which is to attract deposits and loan customers. But what would have happened if Sarah's check had left the cash reserves below the minimum reserves for their deposits? In that case, Sunnydale would have had to do something to increase its reserves. There are a lot of choices, including buying more toasters to attract more new depositors, selling some securities, borrowing in the Fed funds market, pledging securities for a repo loan, selling some artwork, bidding for funds in the large CD or Eurodollar market, selling more bank stock, selling their financial advice, leasing some of their intangible property, lying about their revenues to get a tax refund, whatever. The choice they make is a management decision; what matters to the compliance department is that the reserves return to an adequate level. What matters to the shareholders is that this be done in a sustainable and at least moderately intelligent fashion. Some shareholders may care whether it is legal, too. 
Lending reality 
An important point about lending is that arranging a loan and the legal documents surrounding a loan takes time and effort. Finding loan customers takes time and persuading them to work with you takes time. Even filling out loan agreements takes time. Bank investors and examiners routinely say that it takes at least three