Banking economics fundamentals

Picture a group of people living on an isolated island. Some grow fruit, others fish. They barter their products to achieve a balanced diet. When fruit is in low supply some agrarians go hungry. When fishing is poor some fishermen go hungry. Now a banker sails up in his yacht and says “you’re doing it all wrong – if you borrow from me when you are short you can eat all the time ! Pay me back when your crop or fish come in and it will all be for the better.” The banker charges interest – a tenth share of the value. Of course the result is that the folks end up with what they originally had, less a tenth, but they no longer have periods of feast and famine. This is the essence of financial intermediation. Over time the banker grows rich by creaming a share off the economic production of the islanders.

Financial intermediation started thousands of years ago to mitigate timing differences in traders accounts. Agricultural loans made at planting time were paid back when crops were sold, trade goods financed at the beginning of a voyage were paid back when ships returned to port and sold their cargos. The banker earns a slice for underwriting risk of default on loans and providing guarantees of safe haven plus a small return to depositors (those who have acculmulated surplus).

Surplus is what makes this world work. Our island friends produced none, so banking was a drain on their economy. Farmers and Traders create surplus by growing more than they can eat or arbitraging surpluses of goods between markets. The farmers and tradres only survive in the long run if their surplus exceeds the cost of borrowing. This is an essential truth:

Economic surplus > Interest rate = Growth in personal wealth for all

Economic surplus < Interest rate = Growth in Banker’s share of wealth

This is perhaps a bit oversimplified, but fundamentally true. Regardless of the relation of interest rates and economic growth Bankers gain a greater share of wealth in the economy. It is the only industry that exhibits this behaviour. Small wonder banks are a great investment ! It is the only economic game where the house always wins.

This is not a rant against banks. There is value in intermediation between creditors and debtors (market making and underwriting) and the efficiency of intermediation is a real wealth creating phenomenon. So too is there value in facilitating exchange of value with currency instead of barter – a huge efficiency we take for granted. Without banks the world would be much poorer. What we need to remember is that this is a special industry that is pre-ordained to take over the economy unless properly regulated.

David McNab