The eternal conflicts of interest within banking? – NEVER trust a banker

Banking is a diverse and confusing industry to understand. But it is filled with GLARING conflicts of interest in all areas. Below I am going to outline how banks make money out of different areas of their business, and why they are never on the client’s side no matter how much regulation is put in place.

There are 3 main areas of a large bank:

Retail and Commercial

Traditionally banks were relatively small institutions that used to take deposits and make loans. They would make money by paying savers a smaller interest rate than they would charge on the loans they were giving out. There would hopefully be not too many defaults on these loans, and the banks would make a healthy margin. 

Then there came fractional reserve banking, which allowed a bank with $100 in deposits to make loans of more. This was to charge the financial system and allow banks to create money effectively out of thin air. As the extra loans are being repaid, it allowed banks to supercharge their profits and make even more money from their deposit base. But because you are issuing a lot more credit than you have deposits backing them, if just a small percentage of loans default, the bank is in big trouble.

Generally speaking this is seen as a very stable business but there have certainly been plenty of examples of huge mishaps such as the subprime lending crisis.

Investment Banking

This is generally split into 2 areas known broadly as the capital markets part and the advisory part. The capital markets deals with trading in financial securities, raising capital for large companies, executing trades for clients and (even with all the regulation in place) taking large risks with the bank’s capital. Generally speaking, when markets are volatile and trading volumes are high, this divisions does very well. But when markets are volatile and volumes are very low, this division generally does badly.

On the advisory side, this area helps with advising large companies about potential mergers and acquisitions, consult on restructurings, explore equity raisings, and are generally paid a very handsome fee for consulting on any area where a company may want to access the capital markets. This is generally seen as a risk free area of the bank, and potential profits are extremely high.

Asset Management

Most large banks have an asset management arm to deal with high net worth individuals on their books. This area tries to get these wealthy individuals to buy products that make the bank money. As long as the client trades a lot the bank will earn fees, commissions and trading revenues.

Never trust a banker

Business volumes are the key to a bank’s profitability, therefore all they want is for their clients to trade a lot, or make lots of different acquisitions, irrespective of whether it is beneficial to the client. Some banks even hire multiple researchers in the same area with differing opinions, so that no matter what your view, someone at the  bank is there to help agree with your idea profusely and then push you into trading with them.

With trading, every penny lost by the client is a potential penny gained by the bank. Therefore if the bank is doing a trade for you, will they be working that trade to your benefit of theirs?

Will a bank regularly pitch for a client to not acquire another company, and foregoing their potentially large fees for nothing instead?

The banking industry is littered with these fundamental conflicts of interest that policy makers believe they can regulate. Outside of this business there are plenty of lovely people, but when dealing with a bank in business, you must understand how they are making their money from you. But no matter how hard you try, you can’t regulate human nature.