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Meltdown 101: How do banks make (or lose) money?

WASHINGTON – It’s easy to think of banks as imposing granite fortresses buttressed by columns and adorned with marble, places whose very structure exudes strength and safety.

But they’re really networks of electronic rivers of money flowing in and out in a torrent of transactions. And lately, a new tributary has been added: an unprecedented government bailout that’s directed hundreds of billions of dollars to the banks.

How do the ever-shifting financial currents translate into a bank making money — or losing it?

Here are some questions and answers about how banks operate, as the market looks anxiously toward the first indications of how major U.S. banks performed in the first quarter.

Q: First of all: What is a bank? Are there different kinds?

A: Banks have been around about as long as civil society; they operated as money lenders as far back as the Roman Empire. The first government-licensed deposit bank is believed to have been established in Genoa, Italy, around 1400.

There are roughly 8,300 federally insured banks and savings and loans in the U.S., and their number has been diminishing in the soured economy and foreclosure crisis. Twenty-five U.S. banks failed in 2008, far more than in the previous five years combined, and already this year 21 have succumbed.

There’s a whole range of services and activities a bank might offer: savings accounts, checking accounts, investment services, personal loans, business loans, mortgages, car loans, boat loans, Internet banking, as well as financing of stock issues and mergers by investment bankers, private banking for wealthy individuals and families, and tax shelters in offshore operations.

The panoply runs from the giant Wall Street institutions to the local community bank with a screen door on the branch office and doughnuts in the lobby.

Many big financial institutions combine several of these services under one roof. And a 1999 U.S. law broke down the Depression-era barriers between banking, securities investment and insurance, allowing banks to become financial “supermarkets” selling all three types of services to their customers.

The basic operation is simple: You take money in as deposits and from other sources, and you lend money out. If you’re a bank, loans are assets because you earn interest on them and deposits are liabilities because you have to pay interest on those.

Q: So how do you make money?

A: It’s all about the spread. That’s the difference between the interest rate a bank pays on money it borrows, from the government or other banks, for example, and the (higher) rate it charges the people and companies that borrow money from the bank. Your bank may be charging you, say, an annual rate of 7 percent on a car loan while it borrows at the fed funds rate — what banks charge each other for overnight loans — of 0.25 percent. (That’s down from 2.25 percent a year ago.)

“They make it on the spread,” says James Galbraith, an economist at the University of Texas at Austin. “Banks have spent lots of time and effort to figure out ways other than that to make money, and that’s what got them into trouble.” (More on that later.)

In setting the rates they charge on loans, banks take into account the potential risk of default, so they charge higher rates for customers they deem to be riskier.

Banks also can get emergency loans through the Federal Reserve’s so-called discount window, where the current rate is 0.5 percent, down from 2.5 percent a year ago. Those loans have soared by billions during the financial crisis that struck with force last September.

Banks also make money from the fees they charge on accounts and transactions. For many major banks, a big chunk of their revenue comes from interest and fees charged on credit cards. The investment brokerage business that took hold at “supermarket” banks has generated profits because of the fees involved. And banks make money from their own investments — that’s where the trouble came in for many of them in the ongoing crisis.

Q: So now we’re looking at how they can lose money.

A: Exactly. Major banks invested like crazy in the securities tied to high-risk, subprime mortgages that became toxic when home-loan defaults began to soar. Powerhouse banks like Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. lost billions from them, starting in 2007.

And investments in financial derivatives like credit default swaps — a form of insurance against loan defaults — have brought losses and regrets.

Also, banks around the country have run into trouble on their loans for construction and development, the fastest-growing category of troubled loans for U.S. banks, especially in overbuilt areas. Many banks have heavy concentrations of them in their lending portfolios, and some small banks are considered by regulators to be particularly vulnerable. Delinquent loan payments and defaults by commercial and residential developers have surged to the highest levels since the early 1990s — the latter part of the savings and loan crisis.

Overall, though, smaller community banks have generally fared better than other financial institutions because they tended to avoid exposure to high-risk mortgages and commercial real estate loans.

As this whole mess was becoming painfully apparent, the government came in last fall with the bank bailout, paying hundreds of billions of dollars to buy stock in institutions to shore up their balance sheets and prod them to start lending again.

Q: It seems like, in good times at least, running a bank is a pretty nice business.

A: Right. A show number in the New York Financial Writers Association’s 1984 production of its “Financial Follies” seems especially prescient. It’s sung to the tune of “Be a Clown”:

“Be a bank, be a bank,

How the Fed loves a bank;

Wear blue suits and black shoes

And there’s just no way you can lose;

Take a risk, take a chance,

Son, you can’t go wrong in finance.

...

When you’re up you make out

And when you’re down you’re bailed out.

...

Just call on Uncle Sam and he’ll make everyone whole.

Be a bank, be a bank, be a bank.”