Understanding The Banking Sector

What is Debt, Asset and Cash Flow?

When a person deposits money into the bank, where does it go? Usually all the money in the world which exists is a debt. To understand banking, it is very important to understand certain terms like Debt, Asset and Cash Flow.

So, Debt is a process of borrowing money from one person/organization. But debt is not simple as it sounds, to understand banking sector we have to learn a new definition of debt, debt is a promise that financial institutions like banks makes when they give out notes to the payee.

Let’s make it simpler, “I promise to pay the bearer the sum of ₹100” can be found on any Indian currency note which is signed by Governor of India. Similar versions of promise can be found on foreign currencies as well. Here, RBI is making a promise of paying ₹100 of Goods/Gold or anything which has an equal value as that of ₹100 on demand, this creates DEBT=MONEY situation, but 3-8% of actual money is in the form of physical money like notes. Rest of the money is in form of digital money; here as well same promise is made by issuer.

Now, lets understand what are Assets, asset is any thing whose value increases overtime along with that it also generates income. For example, a Share in a certain company is an asset because as time passes the company will grow along with it value of share will also grow, as well in form of dividend share will generate income.

When this generate income is used to buy an item, it creates a cash flow as money travelled, cash flow can also be called as exchanging hands.

How Banks Operate

Usually bank store only 10% of there total deposits and lends 90% as loan to other institutions. The institution or person who borrows money have to pay that back along with interest.

This interest is were banks make profit, banks also invest their money in assets and derivatives; Derivates are financial instruments which derives their value from an underlying asset. Trading in derivates helps bank to make more money which they lend back to people and cycle is continued.

Borrowing money is very important to run a economy of a nation, if a person borrows money from a bank to buy a house which he/she cannot afford, it creates a chain reaction in micro economy, selling that house helps the builder, labor, cement and other companies to earn income.

In fact when bank gives out loan, it literally creates that money digitally and gives it to the borrower, it happens because as we saw debt is nothing but a promise to pay back, when borrower returns the money which was borrowed it has to be returned at an interest, then the vacuum which was created by creating money digitally by bank is filled and remaining interest is profit.

The art here is to verify weather the borrower is able to repay the bank after fixed amount of time, so if a lot of heavy loans gets default then, as bank which only has 10% of money in cash fails to repay its depositors their money back.

During financial crisis of 2008-2009 were a Lehman Brothers Bank gave out loans to anyone who wanted to buy a house in US and Europe, as house was a safe bet, because if borrower failed to pay back, they can take over the house. But when housing market collapsed in US, Lehman Brothers were forced to declare bankruptcy overnight, which created very serious downfall in world. Later, Federal Reserved had to buy all the bad assets.

In conclusion, banks have come a long way from borrowing at low interest and lending at high interest. Banks have became more and more complex than they used to be and its just not possible to fully understand their function.