“‘Tatty’ (thirty) billion for the account…”.
It is fair to say that these words made the famous song “If” by Nigerian
afro-beats sensation, Davido, the success that it was. In hip-hop, R&B and afro-beats,
where bragging about riches and success is by far the most popular theme, there
have not been many songs or musicians who have been able to express this theme
as effortlessly as Davido did in “If” (Don’t be dismayed if you do not know the
song. Here’s a YouTube
link for your listening pleasure).
The video to the song was published on
YouTube in February 2017. At that time, if Davido truly had 30 billion naira in
his bank account – which he has confirmed he did not have -, it would have been
worth around 99 million US dollars. Today, that same sum would only be worth
around 77 million dollars and is likely to be worth a lot less in another three
years.
I do not plan on writing about the
devaluation of the naira today, besides, I already shared some of my views on
this topic here.
Instead, I will like to follow-up on my last post, where I wrote about Mutual
Funds and suggested that cash held for near-term purchases (two months to a
year) and contingency funds held in case of emergencies be invested in money
market mutual funds, instead of in bank savings accounts. We now examine how
banks operate and what they do with your money.
What are banks?
Investopedia defines a bank as a financial
institution licensed to receive deposits (from you) and make loans (to other
individuals, businesses or government agencies). Did you see that? Even a bank
does not keep / save the money you keep with them.
This does not imply that banks are bad. On
the contrary, banks play an important role in every society and they are
essential for financial markets to function. They provide vital services to
stakeholders in most societies and without them, societies could very easily
descend into chaos.
Banks help process transactions daily to
allow individuals and organizations engage with one another financially, with
relative ease. They also help store cash and other valuables for individuals
and businesses and reduce the physical handling of cash, with all its
associated risks.
There are different types of banks and
different types of bank accounts but in this piece I refer mainly to deposit
money / commercial banks, as well as to savings / checking accounts.
What do banks do with your money?
Perhaps most importantly (from a finance
perspective), banks help financial markets function efficiently by distributing
cash from where it is least needed (your bank account) to where it would be put
to better use, in the form of loans to individuals and businesses.
These individuals and businesses, in turn,
deploy the cash to productive tasks in the economy, such as trading in physical
goods and services, construction, manufacturing, purchase of equipment, etc.
These productive tasks, by using this cash effectively, improve the lives of
entrepreneurs and business owners, boost employment, and so on.
Banks earn a fee for ensuring that capital
is distributed efficiently to where it is most needed (by investing your
money). This fee is for the services that they provide, and it is only fair
that they are compensated for it. In the same vein, since banks typically
provide their services by utilizing your money, it is also
fair that you are compensated for this. As a result, most banks pay you
interest income for cash held in your deposit accounts.
However, the interest income you receive
from the bank is usually a fraction of the bank’s earnings. In fact, it is often
so little that you would be forgiven for not recognizing the credit entry in
your bank account. Also, because you can withdraw the amount of money in your
savings / checking account without giving any notice to the bank, the bank is
somewhat restricted in the kind of activities to which it can divert your
money.
Accordingly, cash held in savings accounts
are often invested by the banks in the most liquid securities, including short
term government securities such as treasury bills, etc. This is one
justification that banks give for the low returns earned on your savings. Highly
liquid securities such as treasury bills are low risk securities with near-term
maturity and, in theory, have the lowest expected returns of all traditional
asset classes. I will be discussing the relationship between risk and returns
this Sunday on the Podcast (Smart Investing
with Nosa).
It is also worth noting that some banks
charge you (my bank in Germany charges me about €2 monthly for operating my bank
account) for helping you operate a bank account. Nigerian banks are also
notorious for charges such as ATM maintenance costs - whether or not you use
the ATM - and you pay for a new ATM card when the old one expires.
Why should I not save my money in the bank?
In today’s world, it is almost impossible
for an individual to function in society without operating a bank account –
even famous drug lords and notorious terrorists have been known to have
operated bank accounts in their names or aliases, or through shell companies.
Hence, I am not asking that you shun your banks completely.
However, some of the short-term securities
in which banks invest their short-term debt - your deposits – are
also available to individuals and to most money managers. This means that you could
directly, or through a money manager, invest and earn significantly higher
returns on the deposits / savings in your bank account than the bank is paying
you for holding your money.
What practical alternatives are there?
Money market mutual funds are arguably the
best alternative to traditional bank deposits / bank savings for certain
portions (certainly not all – see explanation below) of your cash holdings.
They are safe, liquid and provide higher returns that any savings account will.
I explained the features of money market mutual funds in this
article so I will not go into them here. However, I will describe some key
points to note about money market mutual funds vs banks.
·
Although money market mutual
funds offer great liquidity, they are not as liquid as the liquidity available
with savings / checking accounts.
·
Deposits with most commercial
banks are insured (up to a maximum amount in some countries) so that in the
event that the bank runs into financial difficulties and is unable to pay back
cash deposited by customers, these customers – you – will get
their money back and will not be left stranded. This type of insurance is not
as common or as extensive with money market mutual funds.
While it is convenient and advisable to
maintain a bank account, and to ensure that cash needed to meet your day-to-day
(monthly) needs are available in such an account, it often is in your best
interest to transfer all cash in excess of what is needed to run your monthly
affairs to an investment account.
Cash savings for near-term purchases and
contingency funds are usually better off in money market mutual funds where
they can provide liquidity but with higher returns. Cash savings held for
longer term goals (not needed for emergencies or for near-term purchases)
should be invested in other asset classes or investment vehicles (not in money
market mutual funds) that will generate higher expected returns (albeit with
higher risk).
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