Investors FYI - How the banks work

The Fractional Reserve System (which all banks operate on) is one that allows banks to borrow your funds in order to lend it someone else (technically speaking).

Here's how it works; bank A's fractional reserve rate is 10% and you give them $100,000 of your money to place into a savings account, they're obligated to place $10,000 in reserve ( out of your $100,000) and lend out the remaining $90,000.

Obviously when they lend out the remaining $90,000 they will charge interest. Let's say Bank A pays you 2% interest for saving with them, and charges 6% interest on the $90,000 they lend out.

Over 12 months the bank will pay you (the saver) $2000 or 2% interest for your $100,000 deposit. However the borrower with the $90,000 loan will pay the bank $5,400 interest. So the bank makes money from lending your money to others.

Due to this banking regulation, all banks must ensure their borrowers can repay the funds borrowed funds, plus interest, so they have what's known as a 'risk grade' for different assets.

Here's a tip for all investors: if you're smart about it, you can use this information to identify which asset class is the "safest" place to put your hard earned cash.

Just follow the banks' collective "lead" in relation to where they perceive risk is and where their comfort zone sits.

Remember that our banks and other lenders are in the business of making money by lending money - they're experts at risk analysis. They have to be if they want to get their money back!

So they assess their lending and interest rate on offer using a simple explanation: 'rate for risk'.

Which translated into English means: the riskier the security, and/or borrower and/or business venture then the lower the percentage (lower LVR) we will lend you against that security and the higher the interest rate we'll charge you will be.

How do you follow their lead? By identifying the Loan to Value Ratio (LVR) that your bank will lend against each of the three primary asset types.

Remember - the riskier the bank perceives the asset to be, the lower the LVR they'll be willing to lend against it.

It's interesting that the major banks and other lending institutions will lend up to 95% against prime residential real estate at 3 year fixed rates as low as 4.79%. Some variable rates are now also around 4.80%. These are historically low rates!  However these same lending institutions will lend a maximum of 65% against the value of prime commercial real estate and depending on your risk assessment as a borrower, the interest rate on this commercial property will most likely be between 6.00% and 8.5%. NB - some lenders will still lend up to 75% on commercial property at a higher interest rate: usually an extra 1%.

What about the Stock Market? Everyone knows someone who's made a killing in the stock market over the past year, don't we. Really?

Well here's what the Big Four banks think of shares as security for a loan.

When you borrow to purchase shares and use the shares as security for the loan it's referred to as a Margin Loan. For the uninitiated the maximum LVR they're willing to lend to can be a shock to the system. In fact most shares are not acceptable as security for a Margin Loan - especially if you're purchasing shares in just one company. That's considered to be even more risky.

For example - buy 20,000 Telstra shares on their own and CBA will lend you just 65%. Buy them as part of a portfolio and they'll lend to 75%.

Guess what CBA thinks of CBA shares as the security for a loan - exactly the same. 65% for stand alone shares vs 75% if they're held inside a portfolio.

Want to splash out on some mining shares do you? Maybe you might want to rethink that: shares in many of the listed mining, energy & resource companies will only get a 40% LVR inside a portfolio and zero as a stand alone purchase.

And if you're borrowing on a Margin Loan to purchase shares - be prepared for the interest rate to be upwards of 9%.

Remember - the bank's #1 job is to make money and hand in hand with that is their assessment of risk.
So, what does this all mean for you?

Simply this: If you want to invest wisely and safely, you would be well advised to follow the Banks' lead. If they perceive residential real estate as being the asset class with the least risk, then you should consider residential real estate as your primary investment choice.

Unfortunately not every residential property is a smart investment opportunity. If you don't know how to identify the right properties, you run the heavy risk of investing in a property that is negatively geared, will cost you money and will restrict you from growing your portfolio. But, a smart property adviser can give you the criteria for finding cashflow positive properties that will work for you and your portfolio.