Along comes Caitlin, who says: "I need to borrow 100 bucks, to buy a doll house."
Banker Bobby quickly replies: I'll give you the 100 bucks in my bank, but on one condition. You have to pay me back at a higher interest rate than what I'm paying Alex. That way I can make some money. So, let's say you pay 6% interest.
Caitlin agrees and the 100 changes hands.
Banker Bobby marvels to himself, "I'm in business. This is great. I'm getting 6% from Caitlin. I pay 3% to Alex, and I get to keep the difference. Now let me get some more depositors and some more borrowers."
At a fundamental level, banking is really this simple. You pay your depositors a low rate, and then you lend out money at a higher rate, and you keep the difference.
So with that preparation, let's now look at the world's simplest bank balance sheet.
Picture a piece of paper with a line drawn down the middle. On the right side is Banker Bobby's ten dollars, the ten bucks that he started the bank with, plus the 90 bucks he got from Alex. On the left side ... is the 100 bucks he gave to Caitlin. If you notice, both sides are equal. Ninety plus ten on the right side, equals a hundred on the left side. And that's why they call it a balance sheet. Both sides have to balance.
Ok, now some jargon, to prepare us for real banking. Banker Bobby's ten dollars? That's called the bank's capital. The people that own the bank own that. And when Banker Bobby makes his profit every year -- you know the difference between what he's getting from Caitlin, and what he's giving to depositor Alex, that profit is added to the capital on the right side of the sheet, that the bank owns.
So year over year, if the bank is well run, the capital gets bigger and Banker Bobby gets richer. But now the jargon gets completely confusing and backwards because most of us aren't used to thinking like a bank: The 90 bucks that Alex deposited in Banker Bobby's bank, also has a name, and it's called liabilities." To Alex of course, it's not liability, it's a deposit, it's his savings, but to Banker Bobby it's a liability. Why? Because he owes Alex that 90 bucks, he's liable to Alex for that money. Alex can withdraw it at any time and Banker Bobby needs to pay Alex interest on it. To Banker Bobby, it's like a loan Alex gave him.
So now let's gently introduce another piece of jargon... That 100 bucks that Banker Bobby gave to Caitlin? That's called an "asset." Caitlin has to pay Banker Bobby some money every month and within 3 years has to pay the entire 100 bucks back, plus 6% interest every year on the amount of the loan that remains outstanding, i.e. on the amount of the loan she hasn't yet paid back, which is referred to as "the principal."
So, when Banker Bobby thinks of Caitlin's dollhouse mortgage, he thinks of it like an investment. He gave Caitlin 100 bucks up front, and she's supposed to pay him back 6% on the principal each year for 3 years, or for however long the dollhouse mortgage is agreed to last. That is Banker Bobby's asset, because Caitlin is legally and financially obliged to pay him that nice return. And if he wants to, he, Banker Bobby, can sell that asset to someone else, who then has the legal right to collect those agreed upon payments from Caitlin, for the life of the loan. This is known as selling a debt instrument or just selling debt, or selling a mortgage.
The point to be understood here is that every bank balance sheet looks this way. On the left side you have assets, and on the right side you have liabilities plus capital. And they always balance out. And this is true from this very simple hypothetical children's bank in a world with one depositor and one dollhouse, right up to the largest and most complicated bank that has ever existed, Citibank whose balance sheet we will now take a look at.
First it says what they have in the way of assets. Instead of 100 dollars in assets, they have 1.95 trillion dollars in assets.
On the other side of the balance sheet, liabilities, 1.8 trillion and capital of 150 billion. Notice that these two sums equal 1.95 trillion. Once again, it all adds up. Assets equal liabilities plus capital. Both sides of the balance sheet are in balance.
So, here's where things get interesting. And here's why we had to make sure you understood bank balance sheets first.
Caitlin comes to Banker Bob and says, "I can't pay my mortgage. I lost my job. So that money I owe you, it's not coming."