How banks make money — off you and me

Customers deposit their money which the bank lends out many times over, in many times its value.

Have you ever asked your bank manager how the system works, and how they make your money ‘grow’? Try it sometime. If he obliges, it will either be revealing, or more likely leave you more confused than before.

The attitude towards private banks is usually of doing customers a favour by keeping their money safe and extending loans. It’s actually equally, if not entirely, the other way round. Customers do the initial favour of depositing their money which the bank lends out many times over, in many times its value, by a unique banking sleight of hand that nobody questions. In a transparent public bank, operated within limits, it becomes a boon for borrowers.

What is a public bank? It works the same way as a private bank, except that its owners are the people, whether of a city, province or entire country and are represented by government bodies, not private individuals or companies. Because a public bank does not have to make profits for shareholders their priority, they can focus on serving their customers more economically and at lower interest rates.

What users need to understand is that money and banking are mechanisms to facilitate buying and selling, paying bills for services as well as investments, instalment payments, and so on. What money does is to bring labour, materials and creativity or business acumen together to reap beneficial and profitable results. So it is more of a very basic service industry than anything else. Since most citizens are involved in economic activity and need such a facility, there should be a public bank to which all citizens have equal access as a right, not just the moneyed or privileged.

As Dr Michael Hudson, Professor of Economics at the University of Missouri explains, a public bank should be like a public utility “the demand isn’t simply to make a public bank but to treat the banks generally as a public utility, just as you treat electric companies or health care as a public utility ... There should be a government bank that offers credit card rates without punitive 30 per cent interest rates … This is how America got strong in the 19^th and early 20^th century …”

Equal rights include the right to credit. Some may feel this means forcibly using the money of those who have earned it legitimately, for others. Not really. Most money — anywhere up to 99 per cent — is new, created by banks (which are authorised to do so) in the act of lending. When they lend, they are providing the borrower spending power for his particular need. Yet, most money is just numbers backed by nothing. But their use as a measure and their allocation and juggling are vital — and probably indispensable — to all economic activity, minor or major. However, a high degree of honesty and transparency are also essentials.

After all the scandals surrounding US banks, it became obvious that the US was not a citadel of public interest banking. There is a single exception though — the Bank of North Dakota. If any financial institution has put all other American banks to shame, it is this. Like the German public banks, it restricts its operations to the people of its own state. North Dakota’s money and banking reserves stay within and are invested within the state.

In 1919, the US state of North Dakota faced a crisis similar to what the rest of America is facing today. To resolve the crisis, the public Bank of North Dakota was created. Today, it is the only one of USA’s 50 states that has been completely untouched by events. Since the financial crash of 2008, it has enjoyed a continuous budget surplus and sought ways to spend its surplus! It not only reduced individual income taxes and property taxes, it was the only state creating new jobs while other states were losing them.

The bank is known for its “participation loans” — joining with smaller banks to compete with larger banks. In this, the community bank initiates and takes responsibility for the loan while the North Dakota Bank contributes money and shares in the risk and profits. It is equally known for its low-interest loans to students, farmers and businesses of all kinds.

A common argument is that banking should be left to the bankers because they are the experts. But we know what happened to the West when they did just that without regulation and oversight. Besides, everyday banking affecting customers is not all that complicated and it’s essential to know enough to discourage anyone taking one for a ride.

A widespread myth is that the bigger the bank, the more efficient it is, costing customers less for services (economies of scale). The truth is the diseconomies set in faster in banks. More personnel and infrastructure for more and complex transactions mean higher costs. Surveys in America have found that private banks extract between 20 to 50 per cent for even the most trivial matters, mostly through hidden charges. Money numbers are a double-edged sword; they can empower but can also mislead and ruin. And the biggest US financial institutions that gutted America are about 300 times the size of the average ‘small’ banks.

The reason why Germany and Japan shot to the top in net exports (while US trails at the bottom of the global list) was because their companies were given easy access to affordable loans from public or cooperatively-owned banks. Even when collaborating with private capital, countries such as Brazil, Russia and India tend to keep a 51 per cent government control over public banks. One of the reasons why most of Pakistan’s millions of artisans and self-made mechanics with high engineering skills have not got ahead was due to the absence of credit on fair terms, something the government could have easily extended. Instead, most banks, private or state, choose who they will endow them with and who they will not. Until the political mentality changes to accord all citizens equal credit as a sharing means of the country’s resources and a part of equal rights, Pakistan will remain a dependant and constantly manipulated country.

Published in The Express Tribune, September 19^th, 2012.