Four Ways a Bank Earns From an Ordinary Household

Everybody knows a bank makes money on interest. Almost nobody can name the other three ways, and the other three are where the design becomes interesting. This article takes an ordinary household, the kind with a chequing account, a mortgage, a card and a savings balance, and follows the money outward: what leaves the household, where it goes, and what job it does once it gets there. Four mechanisms, one section each, described accurately and without complaint, because the object is not to be angry at an institution for behaving like one. The object is to see which parts of the design an ordinary family can arrange for itself and which parts it cannot, and to say the second half as clearly as the first.

The method, declared before it is used

A word about language before the first mechanism, because this article uses one set of words in a way the rest of this site never does.

You will not see this practice, its services or any insurance contract described here as a bank, as banking, or as a banking system. None of them is one. Section 983 of the Bank Act reserves those words, in any language, for describing an actual business of that kind in Canada, its products, its services and the means of obtaining them, and the reservation is right.

But this whole article is a comparison with how real chartered institutions earn, so those words appear throughout, used correctly, to describe those institutions and nothing else. The institution’s side of the comparison keeps its own vocabulary: bank, depositor, borrower, shareholder. What sits on the household’s side is called by its own names and never borrows one of theirs: a contract, a policyowner, a participating policyowner, a premium, a registered plan, capital.

That separation is not cosmetic. A single sentence that let a family word and an institutional word describe the same thing would turn a comparison into a claim of equivalence, and the claim would be false. Where the comparison breaks has its own section near the end, in the body of the article, because a limit printed in a footnote is a limit the writer hoped nobody would reach.

One: the spread

The first mechanism is the one everybody has heard of and almost nobody has looked at closely. A bank pays for money and charges for money, and it lives on the difference. What makes the design powerful is not the size of the gap. It is where the cheap side comes from.

The cheap side is deposits. The Bank of Canada Review reported that retail and commercial deposits made up roughly forty seven per cent of the total liabilities of the six largest Canadian banks as at October 2016, up from about forty per cent at the start of the financial crisis. The same study explains why: banks consider deposits a core source of funding because of their stability over time, while the cost and availability of wholesale funding depend on conditions in global markets and are therefore less stable.

Read that from the household’s side of the desk. A savings balance is not money the household has parked. It is money the institution has borrowed, at a price the institution sets, with no maturity date and no covenant, from a lender who can be relied upon not to move it. There is no cheaper borrowing in commercial life.

The Basel III liquidity and stable funding requirements make the point sharper still. Those rules give favourable treatment to retail deposits as a stable funding source, which is one reason institutions compete hard for ordinary household balances. The household, meanwhile, has usually never thought of itself as being on the lending side of anything.

Two: fees

The second mechanism has nothing to do with the spread and does not depend on it. A fee is earned for administering a transaction, and it is earned whether or not the transaction was a good idea for the person on the other side of the counter. That is not an accusation. It is the definition of a fee.

The structural consequence is worth stating plainly: the institution’s income from this mechanism is tied to activity rather than to outcome. More transactions, more accounts, more transfers, more products, more revenue. A household that consolidates and simplifies reduces this income. A household that adds arrangements increases it. Neither household is doing anything wrong, and the institution is not doing anything wrong either. The incentives simply point in different directions, and knowing which direction each one points is most of what a reader can do with this section.

The Financial Consumer Agency of Canada exists in part because this mechanism is hard for an ordinary customer to see. It publishes what institutions must disclose, what they must make available, and what a customer can complain about and to whom. That is the right place to read the rules rather than a page like this one.

A household cannot reproduce this mechanism at all. There is nobody on the other side of a family’s arrangements to charge, and any suggestion that a family can earn fees from its own money is simply false.

Three: float

The third mechanism is time. Money that has arrived but is not yet available to the person it belongs to is money that exists inside the institution, and while it sits there it does the institution’s work rather than the household’s.

This is a regulated mechanism, not a secret one, and Canada publishes the rules. The Financial Consumer Agency of Canada sets out that a federally regulated institution must make a first tranche of any cheque deposit available immediately, and that the remainder may be held for a number of business days that depends on the amount of the cheque and on how it was deposited. A cheque handed to a teller clears its hold sooner than the same cheque deposited at a machine. A larger cheque may be held longer than a smaller one. The exact thresholds and day counts are published by the Agency and are not printed here, because they are the kind of figure that is amended.

Float is also the reason a payment that leaves an account on Friday afternoon may not arrive anywhere until Monday. Nobody is doing anything improper. The settlement system has working days and the money has to be somewhere while it waits.

A household cannot reproduce this mechanism either, and should not want to. What a household CAN do with it is smaller and duller and considerably more useful: know that the gap exists, and stop treating the date on the transfer screen as the date the money is usable.

Four: leverage

The fourth mechanism is the one that does most of the work, and it is the one no family has any access to whatsoever.

A bank does not lend out the capital its shareholders put in. It carries exposure that is a large multiple of that capital, and how large a multiple is not a matter of appetite. The Office of the Superintendent of Financial Institutions publishes a Leverage Requirements Guideline, and it is short enough to describe exactly: the leverage ratio is the capital measure, which is Tier 1 capital, divided by the exposure measure, which covers on balance sheet exposures, derivative exposures, securities financing transactions and off balance sheet items. An institution must meet or exceed the authorised minimum at all times.

The word minimum is doing the work in that sentence. The ratio is a floor, and the floor is what tells a reader how the business is actually shaped: a relatively small amount of shareholder capital supporting a much larger book of exposure. That is leverage, and leverage is what converts a modest spread on each dollar into the earnings a chartered institution reports.

Nothing in a household can imitate this. A family cannot create money, cannot multiply its capital by taking deposits from the public, and has no regulator authorising it to carry exposure against a thin layer of its own. Any page that tells a reader otherwise is selling a feeling rather than describing a design. The leverage in an insurance arrangement belongs to the insurer and to the pool, never to the policyowner.

What a household can and cannot borrow from the design

Set the four side by side and the honest answer is not the exciting one.

Leverage: not available, in any form. Float: not available, and a household that tried to build a business on payment timing would be running somebody else’s business badly. Fees: not available, because there is nobody to charge.

The spread is the one that is partly available, and even then only in a particular sense. A household cannot borrow at one price and lend at a higher one. What it can do is stop paying a price it did not have to pay. Money that leaves a family permanently as interest to an outside lender is money the family never sees again, and a family that arranges its own capital so that some of its financing happens inside arrangements it controls has changed where that money goes. That is not a spread earned. It is an outflow reduced, and the distinction is the whole of the honesty in this section.

The instruments a household has for that are ordinary and are the ones this firm is certificated to place: a permanent life insurance contract with contractual values and a loan provision, a registered plan, a segregated fund contract, an annuity. None of them is an institution. All of them are contracts, and the contract is what a household actually owns.

Where the comparison breaks

A comparison presented as an equivalence is a misrepresentation, so here are the places this one stops. They belong in the article, not under it.

A household has no fractional leverage and cannot create money. Whatever leverage exists in an insurance arrangement belongs to the insurer and to the pooling of risk across many contracts, and it never belongs to the policyowner.

On a policy loan the insurer is the lender. The interest is owed to the insurer, it is a real cost, and it does not come back to the policyowner as interest. Any effect on dividends is indirect, pooled, discretionary and never guaranteed. Nobody borrows from themselves.

A participating policyowner is not a shareholder of the insurer and does not own an institution. Dividends are declared annually by the directors after a written report from the actuary, they are not guaranteed and they can fall.

A premium is not a deposit and a contract is not a deposit account. Deposit insurance does not apply to a contract of insurance at all; the Assuris protection applies instead, in the shape and to the levels Assuris publishes. What deposit insurance covers takes that apart in full.

Where this article ends, and what follows it

This article describes a design and names the parts of it a household can and cannot use. It deliberately stops short of the strategy that many readers will be thinking of by now, the one built around using the values inside a permanent contract to do a family’s own financing over decades.

It stops there because that strategy has its own home. It is set out in full at ibcfinancial.com, and in French at financierecbi.com. A reader who wants the mechanics, the order of operations and the honest objections should read them there rather than in a summary written on a page about something else.

What belongs here is the groundwork: what a contract is, what a registered plan is, how a participating account is regulated, what a beneficiary designation does, and where a licence ends. Those are the pieces a household needs before any strategy is worth discussing, and they are what this site is for.

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The companion piece to this one is interest paid against interest earned, which puts the first mechanism on a reader’s own figures. What deposit insurance covers marks the boundary between a deposit and a contract. For the contract itself, the participating whole life strategy and why this firm places business with mutual insurers. Transparency and compensation sets out what this firm earns and from whom.