We are entering a new era of innovation that will reshape consumers’ relationships with their banks. In order to understand how banking will evolve in the digital age, it is important to understand its basic premise. While reasonable people can disagree about nuances, at heart, the art of banking is one of skillful record keeping in the double-entry general ledger.
At micro level, banks can be thought of as dividend producing machines seeking deposits and issuing loans. At macro level, they are creators of credit money.1The main determinants of their quality and reliability are the amount of capital and the level of liquidity (essentially central bank money) they keep. In general, a bank would like to maintain the right levels of both – if it has too little, it becomes fragile, if it has too much, it becomes unprofitable and hence unable to fulfill its purpose of paying dividends.
Some of the loans issued by the bank will be repaid as expected, and some will default. In general, when loans are repaid, the bank’s capital grows and when they default, the capital diminishes. If the bank’s capital falls below a certain fraction of its risk-weighted assets, the bank defaults. Good bankers differ from bad ones by their ability to attract a large pool of reliable borrowers, so that default levels stay close to their expected values. (Some defaults are inevitable and are accounted for by charging interest.)