How do banks work? The answer to this question might be changing. In very simple terms banks buy and sell money. They pay interest to customers who put money on deposit with them. They then use that money for several different things.


Mostly they use the money to lend it out to other customers. They charge these customers interest and low and behold the interest charged is greater than the interest they pay their depositors. It is no different than a shop paying a supplier 40c for bread and then selling it for €1 to the customer.  


Unfortunately for banks, particularly in recent years peoples appetite for lending was far greater than the amount of money that was sitting in deposit accounts so the banks had to find a new way of getting their hands on cash in order to satisfy there customers appetite and increase their profits.


Banks have other ways of raising cash; they can borrow from their peers. Banks lend to other banks very regularly. They charge each other for the money and there is market set up for this called the inter bank market.


A bank can also raise cash selling its own shares through what is called a rights issue or they can go to the market and sell a bond. Bondholders are people who give money to the bank and in return the bank agrees to pay a set rate of interest and they also agree to pay them back the money after a certain period of time.


Bondholders get paid more interest than deposit holders sometimes about 2% more per annum, but they also take more risk. Shareholders take the most risk of all and should be repaid the most for their investment if everything goes well.


In the event of a bank failing the first people to be paid are the depositers, at the moment in Ireland if the bank can’t meet all the payments due to deposit holders the government have agreed to pay them back, so very little risk there, thus very little return.


Next in the pecking order is bondholders they will get their money and whatever is left in the pot after that is divided amongst the shareholders.


Another way banks can get money is to borrow it off the central bank in our case the European Central Bank (ECB). Again they are charged by the ECB for this money. The ECB charge them less than the inter bank market, so why don’t they borrow all their money from the ECB? The amount that can be borrowed from the ECB is directly related to the assets the bank holds.


There are several different assets that the ECB will allow banks borrow on the strength of. The most obvious one being deposits. But they are also allowed borrow against any government bonds they own.


Just like banks governments sometimes need to raise cash, they can’t sell shares in the country and they can’t accept deposits so a government will issue a bond. These are considered exceptionally safe bets because they are backed by a government.


One problem Ireland currently has is that we are considered less of a safe bet than the likes of Germany and therefore we have to pay our bondholders more interest in order to attract them.


Irish banks have bought Irish government bonds in truck loads since last October. In fact their holding of government bonds has increased from around €500-600 million last year to around €7.5 billion. This is an increase of €7 billion.


This is huge benefit to everyone, with Irish banks buying about a quarter of all government debt it is pushing demand up and therefore reducing the interest government have to pay.


But where do the banks get the money, we all thought they were strapped for cash? Isn’t that what Nama is for, to give them back some cash and get them lending again. The banks get the money from the ECB of course, using the government bond as security.


The September 15th issue of Irish government bonds to be paid back in 2020 was issued at a yield of 4.913%. This means that Irish banks will get paid 4.913% for every year that they hold that bond.


Lets average it out, lets say that the banks hold €7.5 billion of government bonds at an average yield of 4.5%. They can then borrow that money off the ECB at a current rate of 1%. This means the banks are making €262.5 million per year from a paper transaction backed by the Irish government or in other words backed by the Irish Tax Payer.


Believe me if I could do it I would, no risk, very little paper work and €720,000 a day in interest. The best thing of all is it is not even my money it is the ECB’s.


Another interesting thing here is that one of the biggest beneficiaries of this is the Irish government. They are effectively getting funding from the ECB.


If the banks were nationalised then the Irish Government would become the owners of the bank.  When the government issued a new bond the bank could not buy it because effectively they would be borrowing money from themselves. The ECB just wouldn’t back that.


We all know that the banks need to start lending money again. It is needed to get people buying cars, houses, holidays and house extensions. People need to start to spend to get the country back on its feet. Most commentators agree that the best way out of a recession is to spend.


If you were the bank making good money on riskless transactions would you really walk away from that to give Johnny down the road enough money to buy a second hand car with the chance that Johnny might loose his job and head off for Australia.


We can all complain and moan about the way things work. A lot of people are very angry with the way banks have profiteered. If you think they are out to do nothing but make money that they are ruthless and they will stop at nothing to make profit. Well then buy the share.