“‘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 YouTubelink 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 yourmoney). 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).