How Banks Work
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Modern person cannot imagine the life without different financial services such as deposits, loans, ATMs, clearing, and others. Most of these services are provided by such financial intermediaries as banks, which are the central actors in this field. However, not many people who use the mentioned services think about how banks work, despite the value of these organizations in rapidly developing world. The importance of this issue can be described by real facts in financial business life, such as Financial Crisis 2008.
For this paper I have chosen two videos – “Fears of a Global Financial Crisis” and “Tumbling Home Values”, both of which are related to time of Financial Crises of 2008. The analysis is grounded on Chapter 8 of Textbook, which is discussing the topic “How Banks Work”.
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Banks are financial intermediaries that have profit by borrowing funds from savers as deposits at one interest rate and lending these funds to borrowers at a higher interest rate (Croushore 157). Banks provide resources to those people and businesses that need money for goods, services, or business, stimulating economic growth. Besides, banks can have profit by lending money to other banks that need additional resources. The size of bank`s profit depends on spread. Inability of banks to fulfill these functions can lead to negative consequences as it was in time of Financial Crisis 2008.
In 2008 prices on houses decreased critically. As the video “Tumbling Home Values” shows, this led to a situation when many Americans owed more on their mortgages than their homes were worth. Economists believed nearly 8.8 million Americans had this problem. David Muir provides an example when in 2005,the family took out a mortgage on their home for $244,000, and in 2008 this home cost $230,000 (“Tumbling Home Values”). At that time many financial institutions collapsed. It was especially hard for banks. The situation was critical and it is necessary to know causes of the problem.
From mid-1990 to the mid-2000 prices for houses were increasing (Croushore163). It seems that prices were not in correspondence with economic issues. The cause was in the way of lending money. Loan was accessible for everybody, including those who possess nothing. There were many NINJA Loans (to people with no income, no job, and no assets) (Croushore163). Banks did not check the information about borrowers. On one hand, banks were making profit and economics was growing up. On the other hand, this profit and economical growth were not supported by the rise of production. It was a “bubble” that in one moment had burst. An important principle of banks’ work was violated. According to this principle, a bank has to gather the information about the borrower to determine the ability to repay the loan. History lessons were ignored during a long period. The saving-and-loan crisis had taught the banking system and regulators that banks should be careful about the risks (Croushore 162). Banks forgot it, and this led to negative results.When prices for real estate began to decline in 2007, mentioned above loans became a problem. As many borrowers pay their mortgages with adjustable rate, they depended much on market fluctuations. It was a huge problem for people, and some of them stopped to pay their mortgages. Thus, banks` profit from lending money was miserable.
During Financial Crisis 2008 stock indexes failed dramatically. As Dan Harris in video “Fears of a Global Financial Disaster” points, Dow Jones dropped down 18% in a week because of financial panic in the markets (“Fears of a Global Financial Disaster”). It had a negative effect on banks.The profitability of banks can be measured by return of equity, which is determined as profit divided by the amount of equity capital (Croushore 170). In the time of crisis, this index was at low level because of the absence of profit. Investors withdraw their investments in the financial sector aand look for investment in safer assets. People began to put their money back from banks. Thus, banks were in loss.It was almost impossible for them to borrow funds from savers as deposits at one interest rate and further lent these funds to borrowers at a higher interest rate. Many banks` risks, such as default risk, interest rate risk, sudden withdrawal of a large depositor`s funds risk, were realized.
Andrew Ross Sorkin said that this was the time to invest, because this is when people make money (“Fears of a Global Financial Disaster”). That is arguable. Banks were considered as bad assets, unprofitable and a problem. Stock prices of banks` shares declined. Mutual and hedge funds were also in a worse situation. They were forced to sell their assets in the market (Croushore 163).
It was impossible to solve this problem without government regulations. David Muir in video “Tumbling Home Values” pays attention to options for banks. They could voluntarily refinance mortgages, or sell mortgages to the federal government (“Tumbling Home Values”). Bianna Golodryga in video “Fears of a Global Financial Disaster” points that European leaders proposed an emergency plan to support banks, giving them cash for the restoration of lending. Bush administration proposed plan for $700 billion, which provided partially nationalization of private banks, allowing the government to take ownership in them (“Fears of a Global Financial Disaster”). It could stabilize the market and stop panic.
Finally, the U.S. government developed TARP – Trouble Asset Relief Program, which provided buying the bad assets from banks and recapitalizing them. This program was not working as planned. Later, the government simply invested in banks and gave them capital in exchange for sharing in their future profits.(Croushore 163). In 2010, the Dodd-Frank Act was passed. The Act regulates not only consequences, but also the causes, which can lead to a crisis.
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