22

I apologize if this has been asked before....

If you can reasonably expect to profit 6% or more from index funds and there are other ways to make a reasonably safe 6% on the stock market....
Why do banks loan money to people (for housing, cars, etc.) at 4% and below ?

Edit: Sorry to have been unclear. The question is why does the bank not invest their money in the stock market rather than loaning it to people.

  • 35
    the idea that you are "reasonably certain" to make 6% or so on the markets is a dream. try it, and cry. – Fattie May 10 '18 at 19:20
  • 4
    It is reasonable to think it will... long-term. – Adam S. May 11 '18 at 13:23
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    Long-term gains don't pay your short-term expenses. – chepner May 11 '18 at 14:49
  • economics.stackexchange.com/q/30215/4020 – user44214 Nov 17 at 1:19
19

Why does the bank not invest their money in the stock market rather than loaning it to people?

(Aside from other points made about secured vs unsecured loans and regulations)

As to why your local, commercial bank doesn't, it's because they aren't structured to do so. Mixing "commercial" and "investment" banking was illegal up until about 20 years ago (US-specific), and most banks still just don't mix the two. And if they wanted to, well... it's not easy for a bank to just randomly say "I'd like to put money in the stock market today!"

Now, as to why anybody would make a commercial bank instead of just making investment banks...

Commercial banks can lend on margin or fraction, so they can multiply the profit from a given interest rate.

  • Option One = investing. Let's assume that 6% in the stock is guaranteed. So if the bank has X dollars, they can get X*.06 profit this year by investing it.
  • Option Two = lending. Now let's assume that the bank has a 10% fractional rate and can actually make 10X loans at 4%. They can therefore lend 10X at 4%. This earns them X*.4 profit, which is over 6x greater.

Now, this is over-simplified, and there are a lot of costs I'm ignoring (risk of default, operating expenses, regulatory costs, etc.) In reality, commercial banking is not hugely more profitable than investment banking. The main point is that banks can amplify the earnings they get from these low-interest loans because they can lend out a lot more of them with a given amount of reserves.

As a side-note on details, yes it's true that banks cannot initially lend out 10X on a deposit of X. However, in aggregate, that 90% loaned out will end up back in a bank, where it can then be loaned out, come back, again and again and again. This cycling through the fractional system ends up multiplying the amount of money lent by roughly 10X when you balance things out (for a 10% fraction.) It's important to note that this can be viewed as 'creating' money, since somehow a group of people are owed 10X collectively when there's only X in existence. The fact that the 10X may not all be lent by the original bank is one of those complicating factors. It's complicated, and, like I said, the example is over-simplified.

  • 4
    Fractional rates are for savings accounts, how much of the money that people deposit into the bank they have to keep on hand ready for withdrawals. Banks can get away with keeping only part of it because most of the time people are willing to leave most of their money in the bank indefinitely. That doesn't apply to loans - whoever they're loaning the money to is not going to accept getting just 10% of the money and pretending it's the whole amount. – Douglas May 11 '18 at 20:36
  • @Douglas forgot to mention the cycles involved. It actually works out to about a 10x multiplier when you run the cycles through infinitely (which you do at scale) – Jeutnarg May 11 '18 at 21:04
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    Wouldn't the same logic apply to money spent on stocks? Either way it's money that ends up belonging to someone else, and that will likely find its way back into a bank savings account after some number of transfers. – Douglas May 11 '18 at 22:32
  • @Douglas yes and no. Yes in that the money does go back into circulation. No in that I doubt that you can use fractional lending to make the investment - effectively a fractional rate of 100%. Even if you are allowed to have some rate below 100%, I believe that the regulatory bodies would raise the percentage, thus decreasing the multiplier. I can't really dig much deeper - although if we can find an official in the FDIC, we might be able to – Jeutnarg May 11 '18 at 23:40
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    That would be a legal or regulatory restriction on what banks are allowed to do with the money they aren't keeping in reserve, then, and it is not obvious to me from your answer that such a restriction exists. – Douglas May 12 '18 at 7:25
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Why do banks loan money to people (for housing, cars, etc.) at 4% and below ?

Because loans for specific items are "secured" against those items. You don't pay on that car loan, the bank comes to take the car. There's far less risk to lenders if they lend money for a car (and put their name on the title, and in the case of a car actually hold the title), than if they lend you "unsecured" money. Even if you promise to buy a car with your unsecured money there is far more risk because you might go put it in the stock market, or bet the sure thing at the race track. The bank can't reposes your stock if you can't pay on the loan, and they certainly can't go get your losses back from the track.

For that reason unsecured debt tends to be significantly more expensive than secured debt. Partially to discourage risky arbitrage like the stock market and partially because there is no secured collateral.

If your question is "why would anyone lend for 4% when they could make 6% in the market" the answer is simple risk/reward and volatility aversion. Why does anyone buy a treasury when they could make 6% in the market? Obviously, the market is volatile, some people don't want 100% of their assets in a high volatility/risk environment so they allocate some assets to lower risk lower return assets.

For the specific case of a diversified bank it's a diversification tool. Lending against cars for a highly probable 4% return allows the lender to take the risk on the more risky borrowers, increasing the overall yield of the loan portfolio to maybe 10%. Banks are generally highly levered thanks to our fractional reserve system. Say there's a 10% reserve requirements. A bank takes your $100 and can then turn around and loan $1,000, but it has to be a loan, they're not allowed to "invest" it in the stock market because of separate banking rules. Banks are MASSIVE liquidity providers in our economy even though they couldn't possibly cover all their outstanding liabilities, not by a long shot.

  • 4
    @xyious 6% return is not guaranteed by any means. a loan at 4% is less risk that an equity index that averages 6% buy may return anywhere from 16% to -4% in a given year. – D Stanley May 10 '18 at 19:45
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    You're making two unfounded assumptions - that the bank would prefer (and can afford) to take higher gains after 30 years irrespective of the relative gains and losses likely to occur during those 30 years; and that the "should" you refer to is interchangeable in certainty between a mortgage and an index fund. – Will May 11 '18 at 9:52
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    @xyious If for some reason you don't believe that banks would want to diversify their investments, then the last paragraph should provide the answer: the loan you get isn't coming from the bank's cash reserves, they get it for ""free"" (in massive quotation marks). They don't have an option to put the money into stocks because it's not their money and they're not allowed to use it for anything other than loans. – Moyli May 11 '18 at 12:00
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    "f your question is "why would anyone lend for 4% when they could make 6% in the market" the answer is simple risk/reward and volatility aversion." This is wrong. The answer is law. Banks are not in the business - and a re not allowed - to put money into the market they take in deposits. There isa ton of regulations but ultimately it runs down on taking a cheap credit from somewhere and lending it out for a profit. And core rates from central banks are way below 4%. Banks do not diversify their invesments - they give loans according to very strict regulations. – TomTom May 11 '18 at 12:10
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    @TomTom the motivations for those regulations are still the same ones in this answer. The fact that they carry more weight to a regulator than to the bank (who is not the only party that accrues downside risk when they lend money) doesn't change the central reason for not using deposits in this way, which is risk. – Will May 11 '18 at 13:13
8

If you believe that this time will never be different then you can reasonably expect to profit 6% or more from index funds each year. And then there's a period like 2008 when the market lost 38+ pct. Reasonably safe? Not so much.

Banks loan money out at higher rates than they pay to their customers who deposit money in their bank. They pocket the spread. It's not a bad gig.

  • They don't pocket the whole spread, because not all loans return their book value to the bank because of default. It's still not a bad gig. – Will May 11 '18 at 9:55
  • You totally miss the legal background that banks are not allowed to invest in the stock market outside specific guielines. So, that simply is not an alternative. – TomTom May 11 '18 at 12:13
  • Where are you getting the "lost 60% of their value" number? This site moneychimp.com/features/market_cagr.htm shows 1969-1974 as about the worst period with a 20% drop over that time frame, but I can't find any 60% drop. – JesseM May 11 '18 at 21:34
  • Looked at web site with bad data. Comment corrected. – Bob Baerker May 12 '18 at 0:24
5

The stock market is likely to return 6% in the long term, but in the short term it's pretty volatile, and there can be long periods where it returns less than the 4% they get on loans, even going negative for a while.

But banks need money all the time so they can pay interest, make new loans, handle redemptions, etc. They can't be totally dependent on the vagaries of the stock market. They need safe investments that provide consistent returns. The loans they make are much safer and less volatile than the stock market, because they're secured.

This is similar to the reason why someone close to retirement will shift their investments from stocks to bonds. If they're going to stop receiving regular paychecks, they want safe investments that provide regular income, rather than more risky investments that require long-term averaging of returns.

  • 1
    You totally miss the legal background that banks are not allowed to invest in the stock market outside specific guielines. So, that simply is not an alternative. – TomTom May 11 '18 at 12:13
  • And the reason that legal background exists is because without it banks would be far more likely to go bankrupt. – Peter Green May 11 '18 at 15:57
  • @TomTom Good point. I guess what we're all answering is "Why wouldn't they if they could?" But maybe that's a false premise -- perhaps they would. – Barmar May 11 '18 at 16:26
5

How about we start with "how banking used to work".

There are many people who want to be able to get at their cash whenever they want and know it is "safe". They are willing to hand cash to a bank, so long as that bank promises to be able to provide that cash "on demand" and the bank gives them either some services (magic cash teleportation via ATMs, or interest) in exchange.

Now this doesn't do much good for the bank. I mean, having cash, what good is it if you have to have it ready at all times for someone to take it out? So the bank cheats. It gets 100 people to give it 1000$ "on demand", and then it uses some fraction of that 100,000$ on projects it cannot pull the money out "on demand".

It then fakes having the 1000$ per person available "on demand" by betting that not everyone will want the money at the same time. A reserve of (say) 50,000$ would be more than enough. They can offer the customers 1% annual interest, and then find an investment that returns 3% annual, and make a tidy profit of 500$/year. Scale this up with more customers and bigger deposits and get rich.

But then a run on the bank happens; and the bank doesn't have the money on-hand to give to everyone. The bank now has to sell those assets. Quick selling non-liquid assets is costly, and it could result in the bank not having enough cash to satisfy everyone and give everyone their deposit back.

The riskier and less liquid the assets the bank invested the money in is, the bigger the risk that the bank will be "upside down" and a partial run will bankrupt the bank.

If the bank invests in stocks, the value of the stocks could drop 33%; what more, that is going to correlate with recessions when people start withdrawing more money from the bank (their savings for a rainy day) than they put in. What looked like a great deal (6% average returns!) now ruins the bank.

If the bank finds less volatile assets or more liquid assets that earn money, like loans with secured property, so long as the profit is enough they can pay the cost of getting cash (deposits) and still be able to make a profit.

In essense, the bank is in the business of term arbitrage; they take a whole bunch of people who (think) they want demand-money, and a bunch of people who want non-demand loans (mortgages, say), and they act as a middleman, faking the demand-money (as they don't actually have the cash) and using it to loan out non-demand loans.

Today banks work a bit differently, partly because they have access to the central bank and the right to borrow money from it "almost" at-will. In exchange for that power they have to maintain a certain mix of safe assets, like home mortgages on employment stable people with large down payments, or large stable government bonds, and avoid volatile ones, like stock market investments.

  • This is a good answer. The irony, however, is almost comical. We just had a recession because of mortgages killing banks. – xyious May 11 '18 at 16:10
  • @xyious We just had a recession because of a rampant and wholly unchecked market of derivatives of mortgage backed securities and fraud at mortgage originators. – quid May 11 '18 at 17:33
  • @quid Not because of mortgage defaults in any way at all? – Beanluc May 11 '18 at 17:37
  • Yes. We just had a recession because banks were significantly reducing the standards of which people to lend to, then bundling up risky mortgages into a different product and selling that (no less risky product) as a safe investment to other banks.... – xyious May 11 '18 at 17:38
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    @Beanluc and fraud at mortgage originators which lead to defaults. Throwing in to question the relative safety and stability off lending as a form of investing over simple index fund stock market investing because the recession involved mortgages to some extent is woefully short sighted. A larger pool of higher risk borrowers IS less risk than a single high risk borrower. The math is sound until you throw away the underwriting guidelines and lie about your borrower's financial state. – quid May 11 '18 at 17:41
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Because a credit bank is not an investment fund.

Banks take money (deposits) and give credits. Their behavior is extremely regulated. This means that they have to be secure according to specific standards (i.e. handle a certain amount of loan failures). They refinance often by taking credits from the central bank to refinance (very cheaply).

So, the answer simply is: Because they are not in the business of investing in the stock market and their regulations do not allow this.

0

An institution (like a bank) is required to demonstrate that is has a resilient position. This means that it is supposed to be able to withstand a fall in business performance/share prices etc.

One way of achieving this is to make loans against secure assets (with close to zero risk) at a small profit margin (since this business is highly competitive), and use this to offset their more risky, higher return businesses such as loans to businesses (which likely provide a better return than stock market investments).

0

Banks are very highly leveraged, the difference between their assets (loans, investments) and their liabilities (deposits) is usually relavely small. If the value of the assets drops even slightly below the value of their liabilities and depositors find out then a bank run is likely. The bank run makes their assets/liabilities position worse.

The stock market is a fickle thing. The value of a share depends on how people think the company will perform in future. The value of shares as a whole flucutates up and down with the confidence of investors. In good times shareholders get most of the benefits of the companies success but in bad times they are at the back of the queue for money.

If banks invested most of their deposits in the stock market then when the stock market had a bad year the banks would have a significant chance of going bankrupt. Banks going bankrupt is generally seen as a bad thing. So banks investment strategies are restricted to reduce the chance of that happening.

Secured loans are traditionally seen as low risk, most depositors are likely to pay them back and for those that don't the bank can reposess the asset and get most of the money back. Even unsecured loans while risky individually are seen as low-risk in the aggregate because the risk is far less correlated than it is with stock market.

Of course the events of 2008 question that wisdom....

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As others have said, a loan on a car or a house is a "secured loan". If you don't pay the money back, the bank can take the house or the car, sell it, and get their money. If you default it's a giant pain to the bank, they have to go through the hassle of repossession and selling the asset and they won't get all their money, but they'll get a good chunk of it. So these are very safe loans. They may not make the full interest rate, but they're unlikely to lose money on the deal.

The stock market, on the other hand, is very volatile. The AVERAGE may be 6%, but in any given year it could be much less, or even negative. (It was negative for much of this year. My major investment account just turned positive for the year yesterday.)

Also, on mortgage loans, the bank often collects a bunch of money in addition to the interest. They charge "application fees", "points", and often nickle and dime you with bunches of little fees. If you pay off the loan early -- which many, probably most people do, when they sell the house to buy another house -- this can be a windfall for the bank.

I see many posters have said that commercial banks are forbidden by regulations from investing in the stock market. But that begs the question of, Why? Is it something that the banks would love to do and would make a bundle of money by doing, but federal regulators for no good reason say no? Or do regulations forbid it because it would be a foolish thing to do that would put depositors' money at risk? Or is it something the banks have absolutely no desire to do because it's too risky and so regulations against it are essentially a moot point?

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