than what the bank decides. Then how can profit from lending rates, watered down
by costs of attracting depositors, translate into higher equity rates?
Easily, but dangerously. That’s where the leverage comes in. If the amount borrowed is much larger than the amount invested as equity, absolute profit from borrowing might be large compared to the amount invested. If hens lay only one egg per day,
but I own three hens, then I can eat three eggs a day.
More money lent out, compared to equity invested, presupposes more deposits to lend. The leverage needed, or deposits/equity ratio in the bank’s case, works out to equal the market equity return for investments of equal risk, divided by the market borrowing rate for loans of such term and risk, net of expense percent including
costs of attracting depositors. This has tended to pencil out at about ten to one.
Firms in general are considered risky when leverage (debt/equity in that case) reaches one to one. Four to six is more typical. Not ten to one. Banks invest in loans, which are safer. But not ten times safer. Few people today would risk their money in bank deposits without federal deposit insurance. My own reading of history finds that deposit-and-lend banks have failed systemically, or needed bailouts, about once per generation since they were innovated in Marco Polo’s time. They failed because borrowers default in high winds, and defaults are magnified tenfold in effects on stockholders’ investment. We rebuilt them, and the tenfold leverage, because we blamed the high winds rather than the rickety structure. The Practical Pig knew better.
It began occurring to me in the mid 90s that mutual funds might replace bank deposits, and deal with the tightrope problem too. Too much money burns holes in pockets today because money earns nothing while we hold it. Mutual funds pay returns, and are owned for their own sake. If their shares were somehow money, people would feel no impatience to spend it, and no supply would be too much. I gradually figured out how the obvious problems in fungibility and divisibility and
other moneyness qualities could be addressed.
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