It is sometimes useful to think that the shareholders of a bank are not its owners; they are just renting it from its creditors. Schematically, a bank borrows a bunch of money from depositors and other creditors and uses the money to make loans and buy securities and do other risky investments. If the investments end up being worth more than the deposits, the shareholders keep what’s left. If the investments end up being worth less than the deposits then, uh, that’s bad. Then the shareholders don’t own the bank anymore, for one thing, but that’s really the least of your problems. The real problem is that the depositors can’t lose money; the banking system relies on bank deposits being usable as money. “Banks are speculative investment funds grafted on top of critical infrastructure,” Matt Klein wrote last week. The liabilities (deposits, etc.) are the critical infrastructure; the assets (loans, securities) are the speculative investment fund. The bank is a machine for turning safe deposits into risky investments. If the investments end up being worth less than the deposits, then regulators and central banks step in and there is some sort of rushed rescue to make sure that the depositors still get paid.
One important consequence of this is that the equity of the bank — the shareholders’ ownership stake — is just a tiny sliver resting on top of an enormous iceberg of liabilities. In a good profitable conservative bank, there might be $100 of assets, $90 of liabilities and thus $10 of equity. The liabilities are certain and knowable, things like deposits that really need to be paid back at 100 cents on the dollar. The assets are risky and variable, and their valuation is a bit of a guess: They include securities with volatile market prices, weird derivatives that are hard to value, and business loans with uncertain probabilities of being paid back. The bank applies some accounting conventions and makes some guesses and comes up with a value of $100 for its assets, but there is a range of uncertainty around that number.