What an Amazing Business

Amar Pandit , CFA , CFP

Can you take a guess about the industry I am referring to?

The award clearly goes to the Banking industry.

It is an outstanding business and here is my oversimplified take on it. This industry had a very simple use case called “custody”. In short, the idea was that we will keep your gold and valuables safe and secure. Thus, they built huge vaults and buildings in prominent locations across the world. Over a period of time as trade scaled exponentially and money originated in the form of currencies, the banks started providing “custody” for your money.

Though there are many nuances, at a basic level, the key marketing strategy here is “fear”. We will keep your money safe and pay you an interest (for you being the owner of this money).

Just think about this for a moment.

Someone who is providing you with custodial services (safety) of your money is not charging you any money but paying you money. Can you imagine any business in the world doing this? This almost sounds like social service, but it is not.

One of the things that people do not understand is that the “custody” of your money is now with the banks. You have given them permission to do whatever with your money. Thus, there is a payment made to you called “interest” for this “permission to do whatever with your money”. You can also look at it as “rent” on your money.

With a free hand on the pool of money that comes for a negligible cost (in the US, this is ZERO and in India, it is in the low single digits or even ZERO), the banks take all possible risks lending it to people and earning a much higher rate of interest. One friendly bank managed to lend Rs.12000 Crore to a diamond merchant and the best part no one senior enough in the bank knew that not Rs. 1 Crore or even Rs.10 Crore but Rs.12000 Crore was lent out on extremely generous and special terms. There are many such generous dole outs that happen. Now while these are exceptions and there are safeguards in place from a risk management perspective, the point is lending is a risky business and you have granted the permission to do so with your money.

The genius of this industry lies in creation of labels that we have all come to accept magnanimously. The labels are Current Account, Saving Accounts but the most powerful one is Fixed Deposit and Recurring Deposits.

I have recreated a sample pitch that I have experienced time and again. I have no doubt that most people would have experienced this too. It’s not said exactly in these words, but they mean exactly this.

“Give us your money. We will pay you a very low rate of interest (Savings Account), and ZERO in your Current Account. Even though we give you a ZERO or low rates of interest, we will give you a Gold, Premier, or Diamond Crown. You are indeed our Jewel (that comes with privileges) and will also have a Special Relationship Officer who will look after you and ensure that you are pitched one life insurance policy after another. After all, we care not only for your money, but we care for your life too.”

The best part is yet to come, and it is this.

Think about the strongest banks in our country or anywhere across the globe. Have you ever wondered if all their depositors landed up tomorrow morning at their doorstep demanding their money back, what do you think would happen? Forget all the depositors, what if only 50% depositors land outside?

Which bank would be able to honour its promise?

This is the beauty of this business. This is the only legal business where an institution can make such a promise or a guarantee that they have your money and can give it to you WHEN, they DO NOT HAVE IT.

Can you imagine any other person or entity promising this when they have lent most of the money they have collected? Any person doing this would be called a Fraud. However, the banks have been granted this power.

American Economist Murray Rothbard in his book “What Has Government Done to Our Money? notes that this arrangement is perhaps the only one in the world in which the seller of a service is allowed to promise to give the depositor his/her money on demand knowing full well that the demand cannot be satisfied if more than a small fraction of depositors simultaneously make the demand.”

That is why it is indeed a special business because:

a. “Fear and Safety” will continue to be part of the human psyche.
b. The Network Effects of Banks are powerful. We have been trained rather brainwashed nicely to trust banks.
c. Most people fall for the illusion of safety in these labels while being completely unaware that a killer called “Lifestyle Inflation” is on the loose.
d. Most people will continue to think Fixed Deposit is Free besides being Guaranteed.
e. Most people and institutions will never land up outside a bank asking for their money to be returned.
f. Most people/institutions will continue to be careless with their money lying in Current accounts at Zero interest and low yielding Savings Account. Most will not look at this as an act of lending money FREE to the bank.

Why else do you think banks own the biggest buildings or the prime property? It is because the business is so amazing that most people do not even realize the embedded, and hidden costs they incur (not to mention the huge opportunity costs).

However, we are entering an era of decentralized finance (thanks to the internet and distributed ledger technology) that has started to encroach on the banking industry’s stronghold. Most of this innovation is happening globally and I see a lot of exciting things happening in the banking and financial services space.

P.S. I am super excited to announce a premium section of my blog that I intend to go live with on May 11th, 2021. I will be writing about money, the future of money, the risks and opportunities, innovation, and the future of finance. I want to make this as affordable as possible for every reader yet maintain a certain level of editorial quality. I would appreciate it if you can click this to indicate your interest and help me discover an optimal pricing for this.