A layman’s guide to the credit crunch, part 2: How do banks work?

I’ve decided that the entire economic crisis as a whole is too difficult for me to explain fully in simple terms (partly because I personally don’t understand it all and partly because there are so many reasons for it), so I’ve decided to re-focus this series of posts slightly.

I will (try to) explain to you exactly how the subprime mortgage market collapsed, and why this is bad for banks and for the economy. It’s not the only major force behind the recession, but it’s a biggie.

If you want to try and understand the entire economic downturn, try these wikipedia articles:

Global financial crisis of 2008-2009

Late 2000s recession

Financial crisis of 2007-2009

Anyway, I will focus on the causes and effects of the subprime mortgage collapse. And to first understand that, we must understand how a bank makes its money.

We all have a bank account, many of us two or three or more. The reason we do this is because our money is safer in a bank than under our beds. Not only this, but the bank usually gives us a (very small) return on our money, in the form of interest. I think my current account pays out about 2% interest per annum, meaning that if I had £100 in my bank for one year, then at the end of the year I would have £102.

But a bank doesn’t just hold onto your money and let you get at it whenever you want, and pay you for the privelige. It lends your money out. Say you and 9 other people all deposit £100 in a bank, the bank would have £1000 on its books. Then someone comes along and asks the bank for a loan. The bank lends this person (let’s call him Dave, because that’s a boring name) £200, leaving the bank with £800 left on its books. But the bank lends the money out to Dave at a rate of, say, 10% per annum. That is, assuming Dave pays nothing on the loan for the first year, he will owe the bank £220. The bank will do the same to Mary and John, lending them £200 then asking for the loan back at the end of the year.

So in total the bank has lent out £600 of the £1000 worth of deposits that I and 9 others placed in the bank at the start of the year. If all the loans are repaid at the end of the first year, then the bank now has £1060. If it pays out the 2% interest on the ten accounts that the bank has (a total of £20), then the bank is left with a year end profit of £40.

The bank’s profit is the difference between the interest it pays on deposits, and the interest it charges on loans. Simple so far.

Next post on what the bank does with those loans after they’ve lent them to you.