Word leaked this week that the “living wills” of five of eight giant banks are inadequate. They will be required to do-over, or be fined this fall.
Speaking personally, as one of the bereaved citizens at a potential big-bank funeral, it is time to move on from grieving about the Great Recession. Get back in touch with reality and the future.
A bank — any bank — takes in cash and pays money to depositors. Cash isn’t worth anything to depositors otherwise. It pays nothing if in your mattress, or in a mayonnaise jar under your porch. You have it, which is nice, but it can’t grow.
You could invest your cash, but that would be dangerous (see “financial markets”).
The great banking fiction
The great banking fiction beginning in the U.S. in 1933: If you put your money in a bank it will be safe, government guaranteed and pay interest. Today it doesn’t pay much, but that’s a separate story.
Another aspect of your cash: It is liquid. You can spend it whenever you want to. You don’t have to sell anything, like a share of stock or a bond or a house, to get your cash. Cash is cash.
Hence another fictional miracle of banking: We’ll pay you interest and you can take your money out whenever you want it.
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To accomplish these miracles, banks — all banks big or small — must take risks with your cash. If banks just held your cash, how are they going to earn any money to pay you?
3 kinds of risk yield the miracles
Banks must take three kinds of risks.
- First is credit risk: We can all earn a higher rate of return if we risk not being paid back.
- Second is “maturity risk”: A bank can earn good money investing your short-term deposit in long-term mortgages.
- Third is “liquidity risk”: Making money by investing in something which can’t be quickly sold — or only by fire sale.
Most of today’s bank critics say, “Instead of investing in all that fancy stuff, why don’t you just make loans?”
Answer: Nothing is more dangerous than making a loan. Loans create all three risks, every time: You might not get paid back, you won’t get paid back soon, and you can’t sell the asset if you need to.
Enter securities and bank size. Securities make good investments for banks: They’ve still got credit risk, but they’re available in any maturity, and they are liquid.
Bank size matters because sophisticated investments require sophisticated management. Ever meet a small-town banker? No offense, but do you want him to manage a portfolio of mortgage-backed securities and their absolutely necessary derivatives? With your money?
The oldest joke about banking: Your money is safe so long as everybody doesn’t try to take it out all at once.
Banks keep a liquidity reserve, so they can pay off a lot of cash demand without being forced to sell illiquid stuff at a loss. But that reserve can’t be too big, or the bank can’t earn enough to pay you interest or make loans.
Even if we make banks ‘fire proof,’ they could still fail
Banks have “capital.” A net worth reserve, a cushion against loss, which likewise must be kept in cash or very low-paying secure stuff. Since Dodd-Frank, bank capital has been jacked to the highest level in modern times. If the bank invests in illiquid stuff, or “maturity mismatch,” then the bank must hold even more capital.
Get the drift? Banks inevitably are high-leverage operations — which, with enough bad luck, can run out of cash. But even if we make them lug around tons of fire-proofing, if enough goes wrong with the economy or the world, they’ll still fail.
Election years have some use. The right side this year seems to favor no government at all. The left side seems to want nothing but government.
There is a sweet spot in there somewhere…“society.” In a functioning society, we share group benefits and losses.
No other entity in civilization more clearly demands shared risks than banks. We must regulate them to the eyeballs, make them as safe as possible, but not paralyze them. Today, we’re right on the edge of paralysis.
And above all else, we must not deceive ourselves about the banking miracles, believe that we can give them our cash and they will pay us and make loans to us — and without risk back to us.
The government guaranteeing your deposit does not have any money except as taxpayers give money to government. It’s self-deception to think that a gazillion dinky banks are safer than a few big ones, but it’s absolutely nuts to insist, “no taxpayer bailouts!”
There isn’t anybody but us, and our cash is in banks. We socialize that risk, as we should, and we cannot escape the need.
Lou Barnes is a mortgage broker based in Boulder, Colorado. He can be reached at lbarnes@pmglending.com.
