At the time of writing this blog, there were a few stories in the news about big banks struggling. The most notable being Silicon Valley Bank in the US and, Credit Suisse. I thought this would be a good opportunity to talk to my daughters a bit more about how banks work and why some of them fail.
Before I go on, please do not worry about your money being in a bank. Assuming you aren’t keeping significant amounts in an individual bank account, then your money is likely to be protected. If you do, however, have a lot of money in one place, then best to seek a bit of independent financial advice.
Before talking to my daughters about why some banks fail, I first explained how banks work!
How banks work!
At the time I was talking to my daughters about this topic, we were sitting at the dining table and there was a big bunch of felt-tip pens ('pens'). I thought I'd use these pens to make teaching them about how banks work more visual.
I got my daughters to imagine that there were 3 children. We called them Anna, Beth and Charlie. Each birthday and Christmas, friends and family would buy each of them some pens. They would use a few of these pens to draw some pictures but many of the pens weren't needed for a while. To avoid the extra pens going missing, they gave the extra pens to me ('the Bank'). I'd look after them and the children could get their pens back whenever they needed them. Let's assume they each gave me 4 pens to look after (so I had 12 pens in total).
Over time, the children kept getting new pens as gifts so they never really asked me for their original 4 pens (each) back.
As I was looking after loads of pens which wouldn't be used for a while, I decided to let some other artists borrow a few of the pens, to draw some pictures which they could then sell. I lent 9 pens to the artists. I made sure I still kept plenty of pens with me, in case the children needed a pen for a new drawing of theirs (i'd kept 3 out of the 12 pens with me).
Once the artists sold their pictures, they bought new pens to replace the ones I let them borrow, plus they gave me extra pens as a thank you for letting them borrow the pens in the first place. I kept some of these extra pens for myself but would also allocate an extra pen to each child. As we all got extra pens, we were all happy!
This is essentially how a bank works. They keep our money (pens) safe. We can get our money back when we want it. Whilst the money is in the bank, the bank lends some of it to other people. For example, the money is given as a mortgage to help people buy a house (a nice reminder of Mortgages).
As the bank makes money from lending our money to other people, they give us a little reward, known as interest ('extra pen’). The bank makes sure that there is still plenty of money in the Safe so that if people need some of their money back it is available.
My eldest daughter then asked a great question:
"What if all the children wanted all their pens back at the same time but you gave some of them to the artists!?!"
A 'Run on the Bank'
Let's go back to the original pen scenario where the 3 children each gave me 4 pens to look after. Now imagine that it was Anna's birthday but this year she wasn't given any more pens from friends and family as the price of pens was too high (a nice reminder of Inflation ). Unfortunately, she was planning on creating a big picture with those pens so was a bit stuck. This meant she came to me and asked for all 4 of her pens back.
I only had 3 pens with me as I'd lent the other 9 pens to the artists. This meant I had to go back to the artists to get some pens back from them. As the artists weren't expecting to give their pens back so soon, they had to sell their unfinished pictures, which was less than ideal. As the pictures were unfinished, the price had to be reduced, so they only received enough money to buy 7 pens (not the 9 I'd let them borrow). Therefore, in total I now had 10 pens (3 that I kept and 7 I'd received back from the artists).
For Anna, this was fine as I could give her the 4 pens she asked for. For Beth and Charlie, however, this was a problem. They had both heard that I had asked the artists to sell unfinished pictures so I didn't have all their pens returned back to me. Beth and Charlie were both worried that they wouldn't get all their pens back, so they ran to the Bank to ask me for their pens.
As it was first come, first served, it was a race to get to me first. This is called ‘A Run on the Bank’. As Charlie arrived there first, he received his 4 pens back. Poor Beth only received 2 pens back. I had no pens left so was forced out of business.
This is how banks can fail. If people do want all their money back at the same time, then they could run out of money and not have enough to pay everyone back.
Clearly, governments in different countries don't want people to avoid putting their money into banks. They therefore ensure that if people do put their money into the bank, then as long as they don’t put too much, they will ensure that they can always get their money back! If they put more than a certain amount (limit) in an individual bank account then the government won’t help return that money.
What happened to Silicon Valley Bank?
I explained to my daughters that in the US, there was one bank, Silicon Valley Bank, where people and companies put a lot of money into individual accounts. The amount of money in these accounts was much larger than the limit which is covered by the government.
Many of the accounts held in the Bank were from technology companies. Over recent years, these companies had been doing really well and were getting lots of new money from different people (investors). However, over recent months, things had not been going so well for technology companies. They weren't getting as much money from people (investors). As they still had to pay for salaries of people that worked there and rent for the offices, they went to the bank to get some of their money back.
Just like the story above, the Bank didn’t have all the money. The bank had lent the money to other people* and couldn't get the full amount it had lent returned as they asked for it sooner than expected (like the unfinished pictures).
*side note for anyone wanting more detail - in this case, they agreed to lend the government money for 10-years in the form of a bond. Essentially, as interest rates had gone up, the deal the bank had with the government wasn’t worth as much so they didn’t get as much money back as planned. You can learn more about bonds here*
As the Bank had lost money, all the other people and companies who had lots of money in their accounts with the Bank got worried. They all rushed to get as much of their money back before everyone else. This meant the Bank had to get more of the money back from those that they lent to and lost even more money.
Soon the Bank ran out of money and people and companies with large amounts of money in an individual account couldn’t get all their money back!! The Bank went out of business.
I note that Silicon Valley Bank is unusual in terms of the number of accounts with very large amounts being held (over 70% were above the limit covered by the US government). A typical bank would have less than 20% of accounts which exceeded the limit.
Key lessons from teaching my kids about banks
Whilst telling my kids this story is to help them understand how banks work (and when they fail) I also wanted to use this story to help them understand the need to make sure their money isn’t all in one place.
If they ever did have a large pool of cash, then I want them to make sure it isn’t all in one bank in case some of it isn’t protected by the government.
It is also important when it comes to investing. If you've read my previous blogs, you'll know that I teach my daughters to invest their money (read how here). They invest in '000’s of companies, via an investment fund (you can more about that here), so they don’t have too much invested in one company, in case that one company goes bust.
Banks are some of the biggest companies in the world and people feel these are a safe investment but as the story above shows, that might not always be the case. Whilst I’m not saying people shouldn’t invest any money into banks, personally, I wouldn’t want all my money to be invested there.
On the topic of investing, my daughters asked “What does the bank do with the money it usually makes when it lends to other people?”. I explained that this money is either used to lend more money to other people (so it can make even more money) and some is given to the people who invest in the banks (again, helping my kids understand how money can grow by investing).
With stories about banks being in trouble in the news, I felt this was a great teachable moment for kids to learn about how banks work (or don't work in some cases).
Most people never learn about what banks actually do with our money! By learning about banks, kids will be learning about borrowing, making sure not to have too much money in one place and also some important lessons about investing!
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p.s. If you want your kids to learn about money topics such as investing and debt using fun stories, why not grab them a copy of Grandpa's Fortune Fables?