Arbitrage

Whenever I say the word “arbitrage” I feel like a bona fide financial wizard. Whether or not you know what this word means, I think we can all agree it has a nice 1800’s vibe to it.

Arbitrage is an important concept in finance. Rather than spew a definition at you, I will explain how this word relates to you in your life. When you deposit a check or have money direct deposited into your savings or checking account, you are happy.

The financial institution (bank, credit union, etc.) where this money is deposited is also happy. You may be under the impression that your hard-earned dollars sit safely inside a vault at the bank. Your intuition would lead you to this conclusion because every time you check your savings and checking account on your home computer you see that you have $7 and $30, respectively. Don’t worry, if you have a lot more money in your accounts, what I am about to share with you still holds true.

In most cases your intuition is right, but in this case, it is wrong. The opportunity to make money off your money is simply too great (in fractional reserve banking). The truth of the matter is that your financial institution loans, invests or purchases stuff (assets) with your money, unbeknownst to you.

So how exactly does this work out?

· You deposit $1,000 in your savings account with BRD bank down the street

· That financial institution takes some percentage of your money (usually 90%) and loans it out to other people. The bank may also invest it and/or purchase assets with your money. Note that you are not aware: who the bank loans your money out to, where the bank invests your money or what assets the bank purchases.

· You check your balance on your: smart phone, computer, laptop, wristwatch or television and your savings account still indicates: $1,000.

Wait a minute. The bank loaned/invested/purchased assets with 90% of your money, yet you still have $1,000 in your bank account?

I know, it’s amazing right, it sounds like I’m making this up, but this is how fractional reserve banking works. Banks (and other financial institutions) must keep a certain amount of cash-on-hand (reserves) to cover withdrawals from customers (the reserve amount is specified by the Federal Reserve). Most of the time, a large quantity of people at the same financial institution do not withdrawal their money at the same time so loaning that money or investing that money or purchasing assets with that money, is not a bad idea. In fact, a bank earns money by loaning, investing and/or purchasing assets with your money. A portion of the money a bank makes is used to hire employees, pay the rent or mortgage at local banking offices, pay utilities to keep servers running and cover all other expenses associated with managing your money. The bank must also pay taxes on the money they make off your money. After all that, any money left over is considered to be a profit. May all accountants out there forgive me for my simplified explanation.

There is a good point to learn from fractional reserve banking: if you learn to make money off of other people’s money (OPM), you can make a lot of money! Most people get stuck in the paradigm of earning “X” amount of dollars per hour. There are only 24 hours in a day. So even if you earn $300 dollars per hour and you work 20 hours per day for 365 days, your income is limited (albeit you are tired, but financially well-off). It is true that if you love what you do you never work a day in your life. But, the best part of using OPM is that you could go to sleep and still make money. Welcome to the world of passive income, having money work for you.

Now what happens if everyone gets really nervous and takes their money out of BRD bank at the same time?

In fractional reserve banking, the government is the lender of last resort. If everyone went to BRD bank to get their money out at the same time (known as a “run on the bank”), the government would step-in to ensure BRD bank could fulfill their financial obligations (stay solvent). Note that the government is not fond of acting as a lender of last resort (and neither are taxpayers). The government does not act as a lender of last resort for all banks, only banks whose failure would cause significant financial disturbances (BRD bank is one of these financially “important” banks).

What would happen if all my money was invested in a “small” financially “unimportant” bank that fails?

You would most likely be protected by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. So your $37 is safe!

You may find it frustrating that banks use your hard-earned money to make a profit while the interest rate in your savings or checking account is nil. There seems to be a sentiment of, “the greedy bankers are screwing us all”.

Two points to consider:

1) Fractional reserve banking has been a system of banking for hundreds of years. It is an imperfect system, but it is effective in that it creates a lot of money out of thin-air (I can feel the accountants wince again). Whether or not this is a “good thing” is another discussion (the word inflation comes to mind). One thing is for certain: banking will continue to evolve as technology develops.

2) While it is true that banks rake in huge profits from OPM, the desire to earn even more money, fuels the economy. Why? Because after making a lot of money, banks invest that money (or a portion of it). A lot of that money is invested in fixed income securities (bonds). Ever wonder how some roads, sewer systems, hospitals or low-income housing is paid for? Many financial institutions purchase bonds to fund these projects.

You are now one step closer to becoming a financial wizard.