Banks effectively create monetary value through leverage and lending
To many, how banks operate remains opaque. To understand any business, the critical insight is grasping how that business generates profit. For banks, profit comes from using debt, whether in the form of customer deposits or government lending against rated securities.
Net Interest Margin: The Core Profit Driver
For banks, profitability is determined by their NIM (Net Interest Margin): the interest earned from lending minus the rate at which the bank borrows. This simple equation drives the entire banking industry.
Some markets have notably high NIMs. Australia, for example, has one of the highest average NIMs globally and is also one of the least competitive countries for banking, with relatively few banks on a per-capita basis. This market structure effectively creates an oligopoly where institutions can maintain wider margins than in more competitive markets.
The Deposit-to-Lending Mechanics
When you deposit money into a bank, along with thousands of other customers, a statistical pattern emerges. There is typically a minimum amount that is always present in the bank at any given time. Banks can then use this predictable liquid cash and, according to regulations, lend out a percentage of it.
In Australia, that lending ratio is typically around 92%. Banks earn interest on these loans through mortgages and other lending products. This is why many deposit accounts are free to open: the interest earned on lending more than covers operational costs.
A Worked Example
Consider a bank with 100,000 customers, each maintaining an average minimum balance of $1,000. The bank now holds $100 million in deposits.
At a 92% lending ratio, the bank can lend out $92 million, for example in house mortgages earning 2% per annum to 920 customers with $100,000 loans each.
This simple transformation from deposits to loans is the foundation of retail banking economics.
The Leverage Multiplier: Tranches and Central Bank Borrowing
This is where banking becomes genuinely interesting. Banks create tranches of securities, essentially bundles rated by risk based on the probability of repayment.
A bank might create a $20 million tranche with a AAA (highest security) rating from its mortgage portfolio. It then approaches the central bank (Reserve Bank of Australia, Federal Reserve, etc.) and borrows against this $20 million tranche at a very low interest rate, perhaps 0.1% for a 5-year term.
The bank then uses that borrowed capital to purchase government bonds yielding a higher rate, say 0.81% annually. The arithmetic becomes clear:
The Profit Calculation
Bond yield: 0.81%
Central bank borrowing cost: 0.10%
Net gain on $20M: 0.71% = $142,000
Plus: 1% net margin on $92M lending = $920,000
Total profit: $1,062,000
Banks can continue providing collateral and leveraging this way, generating what is effectively risk-free profit. With average NIMs of around 1.95% and major banks holding over a trillion dollars in assets, the scale of this operation becomes apparent. This is effectively creating monetary value without printing currency directly.
Assets and Liabilities: The Banking Inversion
A fundamental insight: in banking, the definitions of assets and liabilities are inverted from typical business accounting. For banks, assets are the debt they issue (loans to customers), while liabilities are the deposits they receive.
Understanding and accepting this inversion is essential to understanding bank economics. Leverage, properly managed with regulatory compliance, is a legitimate path to building real wealth. The concepts here are simplified, but the core mechanics remain accurate.
The Risk: Bank Runs and Liquidity
This model works because of statistical predictability in deposit patterns. Bank runs are dangerous precisely because banks do not hold the liquid capital to pay back depositors if more than a small percentage (around 8%) is withdrawn simultaneously. Such an event can destabilize the entire economy.
Banks hedge against this through inter-bank lending to manage liquidity risks. When Bank A experiences higher than normal withdrawals, it can borrow from Bank B to maintain required liquidity ratios.
Implications for Capital Management
The principle underlying banking applies to all capital management: if you have cash, make it work for you. Most people and companies leave cash in the bank, where the bank earns from it. Instead, that capital could be deployed into stocks, bonds, or other instruments to generate compound returns directly.
This is not to say banking is a simple business. Setting up a bank requires significant capital (well above $100 million) and navigating complex regulatory requirements across multiple jurisdictions. But understanding the underlying mechanics provides clarity on why banking remains one of the most profitable sectors in the economy.
First Principles of Banking Economics
- →NIM (Net Interest Margin) is the fundamental profit driver
- →Deposits are liabilities; loans are assets
- →Tranching and central bank leverage multiply returns
- →Liquidity risk is managed through inter-bank lending
- →Market concentration enables higher margins