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How to fund a bank, part I: to understand all is to forgive all

20 April 2018
Charlie Corbett

Regulators have spent too much time tinkering with capital stacks and risk-weights and too little time focused on solving the fundamental problem of short-term illiquidity.

Part 1: To understand all is to forgive all

Not long ago, I asked a friend who had worked in finance for 15 years whether he thought a customer deposit was a bank asset or a bank liability, and it took a good deal of wincing and a scarily elongated pause before he stuttered, nervously: “a liability, I think.” This is worrisome. I am constantly surprised by how few people understand the difference between a bank’s assets and a bank’s liabilities. And this includes a great many people, like my friend, who work in financial services. (He was right, by the way).

And I also think it’s why a lot of people fundamentally misunderstand the true nature of the last financial crisis. People spend too much time focusing on CDOs and sub-prime lending and too little time focusing on the absolute basics of how banks make money. At risk of a storm of protest from seasoned bankers, who will no doubt tell me I am talking in grossly simplistic terms, I am going to admit now, that I intend to speak in grossly simplistic terms.

The bleeding obvious

Banks generate income by lending money and charging interest on it. They lend to people, they lend to companies and they lend to governments. And these loans are referred to as a bank’s assets – because they pay interest. The riskier the loan, the more interest the bank charges.

In order to pay for these assets, banks borrow money from ordinary punters, in the form of deposits, and they borrow money from financial professionals, in the form of loans and bonds. These are referred to as a bank’s liabilities. In other words, they need to pay them back at some stage. Like taking a mortgage to buy a house. Banks also sell shares to raise money, which is known as equity capital, but we’ll come back to that.

Banks make profits because they borrow money on a short-term basis, at a low rate of interest, and then lend it out for a longer period of time, at higher rate of interest. This is called maturity transformation. And it makes the world go around. It means banks can fund small businesses to become big businesses, help Joe Blogs to buy a house, or lend to the government so it can build more houses and pay for the health service.

Financial alchemy

But, despite all these good deeds, maturity transformation also lies at the heart of the 2008/9 financial crisis. In fact, it lies at the heart of all past banking crises and will probably lie at the heart of all future banking crises too.

In the good times this ‘borrow-short-to-lend-long’ business model is flawless. It’s what former Bank of England Governor, Lord Mervyn King, calls the ‘alchemy’ of banking. A banking licence is, quite literally, a licence to print money. A bank takes short-term ‘on demand’ deposits – for which it pays around one or two per cent in interest - and lends it to Joe Blogs for 25 years for his mortgage – for which it charges four or five per cent in interest. Easy money. Only a small fraction of the bank’s customer’s deposits are actually backed by tangible cash-in-the-vault. But that doesn’t matter, in the good times, because everyone has faith that everyone else will be able to pay. “I promise to pay the bearer of …” works.

However, there are two problems with this business model:

  1. The danger that short-term funding costs rise much faster than the bank can make up through lending.

  2. The danger that depositors lose confidence in the bank’s solvency and demand their money back all at the same time. Because most deposits are lent out, the bank does not have enough cash-on-hand to pay people. The system unravels.

The second scenario invariably leads to a good, old-fashioned bank run. Until recently it was thought bank runs belonged to sepia infused past - confined to historical figures who wore straw boaters and lived on Wall Street in 1929. But then, in 2007, Northern Rock happened. And everything changed. Bank runs happen in two ways:

The insolvency-inspired individual bank run

In this scenario, the bank has lent all the money it raised from depositors and short-term lenders (its liabilities) to dodgy companies, unemployed dockers, and foreign dictators (its assets). These loans – which had initially paid enormous rates of interest to the bank - start to go wrong. It becomes increasingly clear the bank is never going to be paid back. People panic, lose confidence in the bank’s ability to pay its obligations, and they all demand their money at the same time. The bank is now officially insolvent and everybody loses their money. It is a total disaster for depositors, who gave over their savings in good faith.

The illiquidity-inspired systemic bank run

Illiquidity-inspired bank runs are much more dangerous than insolvency-inspired bank runs because they infect the entire system – and punish the good banks as well as the bad and the ugly ones. A bank might have done a very good job of lending money to sensible people, sound companies and stable governments – but none of this matters if people panic. If everybody wants their money back at the same time, for whatever reason – rational or irrational - even the most sober of banking institutions will go bust.

Bank of mum and dad

This is what happened in 2008/9. A significant minority of highly irresponsible banks – who invested in dodgy mortgages and complex financial instruments they did not understand – came close to bringing down the entire financial system. Once confidence in the system was lost, it was impossible to regain. No bank would lend to another bank because they had no idea whether they were solvent or not. The system froze up. We called it the credit crunch. And it was up to the central banks – the financial services sector’s bank of mum and dad – to bail everyone out and unfreeze the system.

In short, the financial crisis was caused as much by short-term illiquidity based on a breakdown in confidence, as it was by banks investing in dodgy assets.

My next blog will look the role of central banks in crises, moral hazard, and how regulators focus too much time on capital ratios and risk-weighted assets at banks, and too little on short-term illiquidity problems brought about by (occasionally irrational) catastrophic losses of confidence.

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