The first thing I learned about banks at university was their beneficial ‘transformation’ of idle deposits into loans for industry and households. What we save is the equivalent of what we invest ‒ it’s two sides of the same coin.
This is how banks are tasked to boost money supply, the engine that furthers economic growth. They are restrained only by their obligatory reserves at the central bank, the cost of money, i.e. interest rates, and their own capital.
Bank deposits are safe. Money can be withdrawn at any time. There’s no need to keep our cash under the mattress. This is a promise made by banks and guaranteed by governments (up to an amount that protects the vast majority of account holders).
Bank deposits stay steady, replenished continuously by pay cheques and transfers, despite being in daily flux. It is unnecessary to worry about money held in a bank. Banks are safe by design.
The promise to pay account holders any amount at first demand looked hocus-pocus to us students. If everyone demanded their money back at the same time, no bank would be able to do so. To make such a promise was either reckless, or an outright fraud. No, deposits were sticky, we were explained. They depended on trust, sure. But there was no reason why the banks and the government should not be trusted more than money lying around at home.
Making daily payments necessitates leaving money in the bank. To do so was obligatory if one wished to take out a personal loan or a mortgage. Experienced loan officers, in personal contact with borrowers, made sure that outstanding loans were sensibly granted. The ability to repay a loan was the main criterion to grant one. Securities were a mere formality.
Both suppositions – the stickiness of deposits and the expertise in credit allocation were sorely tested in the last 15 years. The 2007-8 Global Financial Crisis (GFC) demonstrated that most banks had no clue about the solidity of their investment and loan book.
To the dismay of the many, banks and insurance companies had to be rescued in the GFC at enormous cost to taxpayers, governments and the economy. It took years for the shock to subside. The deposit flights that started with Credit Suisse last year, followed by runs on regional US banks this spring, demonstrated that our assumptions about the inertia of daily money were wrong too.
A third assumption, based on our antiquated understanding of banks, was that in their transformative, exclusive role as credit suppliers, banks would be more profitable when interest rates rise. As they would pay little to deposit holders while charging higher interest rates to borrowers, their profitability would be boosted. Not anymore. Deposits are a competitive place nowadays, and credit can be found elsewhere.
Proprietary trading, supplementing a bank’s income, was discouraged and made more costly by regulators in the aftermath of the GFC. Banks were forced into the shrinking, unpromising sector of credit business. Banks are therefore less profitable than they were in the past. Their share price reflects this. Their market capitalisation is often cheaper than the total, real value of their loan book.
Credit can be found elsewhere. Banks were forced into the shrinking, unpromising sector of credit business- Andreas Weitzer
And here we go again. Deposit-flight pulled the rug out from under the feet of banks whose business relied on short-term deposits. (And we thought what made banks vulnerable was the fickleness of interbank lending!) Money market funds lure savers away from banks with higher interest rates. To keep deposits, banks have to pay more for them. But even this might not suffice in a panic.
At the same time, banks are suffering the devaluation of their investments. Loans earning the low interest rates of the past are worth less today, as are seemingly safe government bonds that are debased by rising interest rates. Banks earn much less than we expected. Some even make losses. Their shares are dumped as a result, which makes depositors even more jumpy, which causes shares to fall further. Repeat.
A banking crisis yet again caused by greedy bankers? The cost to wind down deposit-bereft, asset-damaged banks is not minuscule. Shareholders and owners of convertible bank debt are wiped out. The cost to the US credit insurance system for rescuing depositors is levied on other banks, i.e. on all their customers. It is a bailout all but in name.
Have regulators failed? Have inflation-fighting central banks acted too aggressively? Are bankers not competent enough? Are the established rules and incentives unsuitable?
To invest in government bonds is by definition risk-free. For the sake of the argument, let us not focus on emerging markets, or the peculiar situation of the eurozone, a hybrid between centralised monetary policies and localised tax sovereignty. If banks hold such debt, they get 100 per cent of their money back, as long as they hold such paper to maturity.
Accounting rules differ therefore between bonds ‘held to maturity’ (HTM) and ‘held to trade’, which has to be ‘marked to market’, or evaluated on a daily basis. This is fine as long as banks are not forced to tap their HTM holdings.
Yet deposits are not what they used to be. Information and panic spreads at unprecedented speed, necessitating the fire sale of HTM securities whose price plummets in a downward spiral. To raise capital in such a situation was perceived as a sign of distress, not prudence, furthering the doom loop.
The CEOs of the dissolved banks were accused of foolishly mischarging the upward direction of interest rates and blamed for not safeguarding against it. But in truth, nobody knows which direction interest rates will take. The inversion of the yield curve (higher short-term than long-term rates) is a prime example.
Markets, rightly or wrongly, still assume that interest rates will come down any time soon. In that case the banks’ liquidity issues would go away in an instant. The CEOs, like everyone else, were stunned by the unexpected ferocity of deposit flights. Their profit accounting was accurate until it was not.
Their books were in good order, in full accordance with the rules. The fact that the failed banks, once taken over by their bigger competitors, brought fabulous riches to their new masters are proof of this.
UBS could book the absurd profit of USD57 billion in Q1, thanks to its takeover of Credit Swisse. The failed lender’s depressed asset valuation translated into “negative goodwill” for UBS – the unreasonable discount applied to the assets of Credit Swisse.
Could depositor panic have been avoided with limitless deposit insurance? Perhaps. It would also make the absurd business of deposit dispersion obsolete. Regulators, while granting it in the US post-factum, had argued against this. In their view, the risk of deposit flight would discipline bank management.
I think this is nonsense. If depositors have to weigh the safety of their deposits on a daily basis, banking services would become too cumbersome.
It has also been argued that banks should be forced to match their maturity risks. They should keep deposits safely stored at central banks, not making any use of them, while matching their loan book with irrevocable, long-term funds. They should stop being banks, in other words.
What we retail investors should bear in mind is that our assumption that banks are the profiteers of economic growth and rising interest rates is wrong. Banks will be miserable money earners for the foreseeable future. Hampered by regulation, central bank supervision and less regulated competition, it is time to think if we need them at all.
Andreas Weitzer is an independent journalist based in Malta.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com