By Alfred Duncan*
Banks borrow through on-demand deposits and lend these funds long term.
This ‘maturity mismatch’ is an imbalance of timing that they have to manage and which exposes them to risk.
However, the mismatch is valuable to customers who wish to hold on-demand assets but borrow for longer durations, and the vertical integration between deposit and lending products helps banks build relationships which are important for managing and assessing loan risk.
Bank deposits also facilitate trade by providing liquidity: banks offer safe, secure and fast payment services for households and firms. For large transactions in particular, bank payments such as cheques are much more convenient for households and firms than cash transactions.
The flow must go on
The value of banks to the economy is most obvious when the relationships break down.
Bank failures are more widely felt than failures of other firms because of the trade linkages that banks provide: they stop trade in its tracks, severely deplete private net worth, and restrict households’ and firms’ access to credit and investment products.
The propagation of the effects of bank failures through the economy means that when a bank collapses, the social costs felt by firms and households can be greater than the private costs incurred by the failed bank’s shareholders and creditors.
While these social costs can be dampened by government guarantees of bank deposits and by the central bank’s provision of liquidity in crises, both actions reduce the private costs of failure and the incentives for bankers to mitigate risk.
In practice, the social costs of bank failure are so high that governments and central banks cannot credibly commit to not supporting vulnerable or even insolvent banks in a crisis. Whether or not there are explicit government supports in place, the expectation of support in a crisis has an effect on the risk-taking behaviour of bank creditors, shareholders and managers.
All firms fund themselves through a mixture of debt and equity. The optimal debt share of funding (or leverage) is influenced by features of the organisational structure and taxation.
For most firms, an increase in leverage beyond some level would lead to an increase in the interest rates charged by the firm’s lenders.
For banks with deposit guarantees (even if implicit), an increase in leverage may not increase the insolvency risk to depositors; rather, it may increase the risks to the taxpayer (and the potential payoffs to shareholders in good times).
With depositors not demanding a premium for risk, banks have an incentive to pursue risks and leverage ratios that are greater than what would be socially efficient.
Similarly, most firms would be wary of maturity mismatch between assets and liabilities. Any rise in interest rates would quickly raise their cost of capital and could force them to liquidate assets at large discounts.
For banks with central-bank credit lines, the risk of a spike in short-term interest rates is dampened as they have access to the central bank’s funds if the market for their deposits tightens up.
Do guarantees regulate flows … or raise risks?
To the extent that government guarantees and central-bank credit lines reduce the cost of funding for banks, they subsidise leverage and liquidity mismatch, which increases the likelihood of future banking crises.
Hence regulation of banks’ leverage and maturity mismatch is often imposed with the aim of preventing bank failures.
Market discipline is dampened but not eliminated by government supports.
Figure 1 shows two key measures of how the credit risk of New Zealand banks was perceived during the recent subprime financial crisis. Each measure is a credit spread, measuring default risk by taking the difference between the cost of 90-day bank bond borrowing rates and 90-day government bond (NZ Government bills) borrowing rates.
The black line shows the spread associated with offshore borrowing by NZ banks (90-day NZD LIBOR). The orange line shows the spread associated with domestic borrowing by NZ banks (90-day NZD bank bills).
Normally, these measures would be so closely linked that the spread would be negligible: an increase in the borrowing cost in one market would encourage banks to raise funds in the other. However, this link can be disrupted in times of financial stress.
The bankruptcy filing of US-headquartered investment bank Lehman Brothers on 15 September 2008 had dramatic consequences for financial markets. Funds in Lehman Brothers’ brokerage accounts (considered by clients to be safe) were instantly frozen and remain so to this date as the financial behemoth and its subsidiaries work through bankruptcy and administration proceedings in a number of countries.
A dramatic rethink of the safety of financial firms that had been previously considered sound was translated into large withdrawals from bank deposit accounts, investment bank brokerage accounts, and money market funds in major financial centres. This is reflected in the significant volatile spreads following the Lehman Brothers failure.
New Zealand banks were not shielded from the panic, and the interest rates demanded by foreign depositors in particular jumped to around three percentage points above pre-crisis levels. If sustained, such increases in funding costs force banks to stop lending to households and firms and can lead to recessions.
Balancing regulation, risk and value
While leverage and liquidity mismatch are key contributors to bank risk, they are also drivers of banks’ value.
Leverage and liquidity mismatch are essential for the deposit account products that banks provide to customers.
On-demand deposits are useful because they can be readily withdrawn or used for payments, and deposit account activity gives banks information about customers that can be used to better judge their ability to repay loans. The information gathered from deposit accounts makes banks efficient channels of capital allocation, particularly towards entrepreneurs, small businesses and households.
Liquidity mismatch may also impose greater discipline on managers: when debt is on-demand along with deposits, a small proportion of depositors withdrawing their funds can cause a run and force the bank into liquidation.2 Fewer monitoring debtholders are required to impose discipline on managers.
As most bank depositors are uninformed about their bank’s financial health, this disciplining role of on-demand debt may be important for reducing risks taken by bank shareholders and managers.
Implicit or explicit government support may encourage excessive leverage and liquidity mismatch, but regulators need to keep in mind the importance of leverage and on-demand deposits for relationship lending and creditor monitoring of bank managers.
Moreover, any de jure limits may not even be de facto enforceable in many cases.
Banks are peculiar in the sense that each bank’s individual value is due largely to its information advantages over its rivals.
Banks seldom own many tangible assets, and their products are unable to be patented or protected from replication by their peers. In order to make profits in a competitive environment, individual banks must have greater knowledge of the risks and rewards of their products than their rivals do, and they must promote this view with a reputation for soundness and service.
A bank that can more accurately gauge the risk of lending to borrowers in a particular market will be able to earn greater profits in that market over the long term than a bank with less information or less-accurate models. Regulations that are dependent on knowledge of the characteristics of a bank’s assets may be unenforceable if the bank is able to pull the wool over the eyes of the regulator; not unforeseeable when their profits depend on them keeping this informa-tion from their competitors.
Such a package of regulations also needs to be constantly altered and manipulated.
The risks associated with lending or borrowing in a given market will depend on the business cycle, terms of trade, and other market-specific developments.
In isolation, limits on leverage and liquidity metrics may reduce banks’ vulnerabilities to economic shocks. However, regulatory packages that internalise a greater share of the risks of banking may be more effective at reducing the vulnerability of the financial system. Regulations should compel bank managers and shareholders to reduce risk by aligning their incentives with those of the public.
Regulations which simply place caps on observable risk metrics will be less effective, and may reduce the efficiency of the sector.
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In the next issue of Competition & Regulation Times, Alfred Duncan will examine some particular features of the New Zealand banking regulatory framework.
1 This project was suggested by Professor Lewis Evans, who also provided comments on earlier drafts.
2 CW Calomiris & CM Kahn (1991) ‘The Role of Demandable Debt in Structuring Optimal Banking Arrangements’ American Economic Review 81(3) pp497-513.
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Alfred Duncan is a PhD student in financial economics at the University of Glasgow and a former research assistant at ISCR.
This article was first published by the ISCR in the July 2012 issue of their "Competition and Regulation Times". It is republished here with permission.
The ISCR website is here » and a .pdf version of their Issue #38 is here »
10 Comments
Banks borrow through on-demand deposits and lend these funds long term.
This ‘maturity mismatch’ is an imbalance of timing that they have to manage and which exposes them to risk.
However, the mismatch is valuable to customers who wish to hold on-demand assets but borrow for longer durations, and the vertical integration between deposit and lending products helps banks build relationships which are important for managing and assessing loan risk.
Unfortunately for the unwitting retail depositor the banks secure commercial wholesale funds (deposits) at low emergency rates and crowd out certain asset classes at the behest of central banks.
Inevitably a central bank will metaphorically cry "FIRE" and the attempted stampede through the narrow doors of failure ruin banks and depositors alike.
How about the good banks succeed and the bad banks fail. What is the actual risk for our banks these days? Further cuts to the OCR?!
Where did everyone stash their cash after the finance companies disappeared? In the bank.
Welcome the real world people. You will make mistakes. You could lose your job. You will hopefully learn from it. Oh wait, you're a bank so the rules don't apply.
Spare the rod, spoil the child.
No Money Man - I just want the managers of banks to stop rushing into unsustainable utopian returns employing rather tricky asset finance techniques that inevitably go wrong.
Furthermore, the tricky financing allows for off balance sheet registration, hence hidden from public view, so depositors and shareholders are unable to discern whether to demand a greater risk adjusted return or just get out.
If the losses attributable to these out of sight bonus generating gambling bets were ring-fenced from that which unsecured creditors fund on balance sheet I would be more relaxed about my fixation to oversee the demise of the banking bretheren.
Repurchase Agreement markets dicussed by BIS
Excerpt about the tricky bit - who actually has claim to the asset :- the cash lender or the cash borrower? For accounting purposes both do to allow for balance sheet asset/ liabilty offset. And the cash borrower claims the value of the capital movement of the asset as well as the coupon payment minus the carry cost of the repo.
Another operational risk relates to who holds the collateral. There are three types of repo, each with different benefits and costs that are reflected in the repo rate and the haircut: bilateral repo, triparty repo and hold-in-custody repo.
In a bilateral repo, the collateral is held on the balance sheet of the cash provider, granting immediate access in the event of default on the loan. In a triparty repo, an agent stands between the security lender and cash provider and physically controls the securities offered as collateral.
The original counterparties remain as principals to the transaction, but the agent – typically a custodial bank – manages the collateral, making substitutions when necessary, monitoring risk and collecting payments.
Legal title to the collateral remains with the cash provider in case of default. In a hold-in-custody repo,the security lender continues to hold the bond on their own balance sheet in a segregated account, raising the risk to the cash provider.
‘The top-ranking British law practice Linklaters signed off on controversial accounting practices that let Lehman Brothers shift billions of dollars of debt off its balance sheet. This masked the perilous state of the bank’s finances, and for many years misled both investors and regulators….Not only has crooked dealing been a clear and present carbuncle on the City’s reputation for decades, ancillary professional concerns have long been up to their necks in illegal collusion in such activities….Time and again, accusations of wrongdoing are met with appalled sanctimony by those routinely involved in serious misdeeds….only to result in even worse revelations…..And equally, the sentences handed out to miscreants justifiably evoke cries of ‘one law for the rich and another for the poor’.’ Read more
Duncan is in a dreamworld if he thinks the fatheads will regulate the banks to rid the country of the parasitic activity that has reduced this economy to a farce. The wise accept the fact that the system is filthy and adjust their lives and financial activity to avoid the debt disease that the banks are so keen to spread throughout the economy and down through the generations until even the rugrats are taught to use credit cards and to plan a future loaded with debt.
Remind me again..Wolly.??
Just why did every bank in the known world FORCE down the rates, then turn on the magic act.
Was it to encourage the stupid savers, or bail-out the over leveraged inpecunious borrowers and their bwankers, via flim flam and sleight of hand and which-craft and what craft and bail-bonds, Get out of Jail free Bonds and other crafty derivative scams they onsold to others.
The mere fact that it has not worked yet, is not lost on the sane.
Then they wonder why filthy few bwankers and poll-lies are not loved by the same people they try to scam...AGAIN....and again.
Get real...
Imbalance...in deed.
Miss match....ya don't say.
Reputation.......in my opinion.....they all stink....as does anyone who supports FRAUD.
"In practice, the social costs of bank failure are so high that governments and central banks cannot credibly commit to not supporting vulnerable or even insolvent banks in a crisis"
And there you have the admission.......not my words.....mine would be more direct.
The biggest FRAUD this world has ever, ever known.
What would the neighbours think...??...What would the World think???
A bank Robbery...from the inside.....don't they actually lock up people for that.??
Aided and abetted by Presidents, Prime Ministers, and their HONOURABLE MEMBERS.
(I jest.. as ye know...nothing honourable about these dealings, no matter the spin)
This is worth a weekend read:
The problem with depressions, not that I’ve ever been awake during one before, is that you tend to get caught up in the minutiae of the moment – the gripping Libor-rigging scandal, the latest writhe in the agony of Europe, the latest twitch in the US economy.
We rush from scandal to crisis clamouring for each to be punished or redeemed. But interesting as all this is, it distracts from the big picture, the real story, which is that the world has begun an epic, long-term balance sheet adjustment.
Because most western governments are insolvent, fiscal policy is dead. They maxed out their taxing power a long time ago and have been borrowing ever since. When it comes to the economy, governments are a spent force.
This has put central banks in charge, and they basically do one thing only: print money. If all you have is hammer, everything looks like a nail, so central banks naturally think the world’s problem is a lack of money, which they are busily solving.
The problem is a lack of money is not the problem, it’s solvency, and part of the reason for that is too much money, or rather too much credit.
Debt was built up through 30 years of current account imbalances after currencies were finally unshackled from the gold standard in 1971, and the depression of the 70s came to end in 1982.
Central banks, principally the Federal Reserve, complied in the process of debt build-up by holding down interest rates and allowing asset prices to rise, keeping balance sheets in the black.
The credit crisis of 2007-08 brought asset prices down rapidly and rendered banks suddenly insolvent, so they had to be recapitalised by governments. Now the governments of Europe, the US and Japan are insolvent and the only question is when the central banks will monetise their debt – that is, print more money and buy their debts.
Governments and banks, lashed together like cage fighters, have to shrink drastically to reflect the new reality of their balance sheets, but no one wants to shrink and they are fighting that like polecats at the same time as fighting each other.
Rigging Libor, the benchmark interest rate for most global lending, and which is bound to extend far beyond Barclays, was one way the banks attempted to avoid their fate.
As a result of the 30-year boom in their product (credit), banks became too big and, more importantly, came to believe their own bullshit. Bankers became so rich, they naturally felt this was due to their brilliance, so that when the magic stopped working in 2007 they felt no compunction in bending the rules. They were, after all, Masters of the Universe.
The financial industry must now shrink and learn humility. To use investment parlance, the world is overweight banking and it needs to return to the simple task of collecting savings and distributing them to those who require them.
Governments also grew too big and acquired too much self-belief as a result of easy debt. Budget deficits and current account deficits were easily financed by future generations and they are now asking for the money back.
As a result short-term government bailouts in Europe are getting shorter and shorter, and less worthwhile. Greece is in worse shape now than it was before being bailed out. Spain and Italy are heading down the same path.
The governments of Japan and the United States are both insolvent – that is, their debts are greater than they can service for long. There is no alternative than deflation, although they will probably try inflation first – that is, monetising the debt.
But the greatest danger for investors is to not recognise the deflationary forest because you’re too busy watching the trees.
That doesn’t necessarily mean not investing, although for some wary souls it does, but rather it means understanding that we’re in a long bear market that is now five years old and could have 10 years to run, as banks, governments and households go about shrinking their debts to better reflect their assets and income.
Bear markets like this cause heartbreak, but they also create wonderful opportunities.
Follow @AlanKohler on Twitter
http://www.businessspectator.com.au/bs.nsf/Article/Bear-market-opportun…
The question in front of us is: How is the deleveraging of NZ Inc (meaning fonterra, dairy farms and associates) going to play out?
That was well put - full marks that man.
Except for the last sentence. Not many climbed aboard the Carpathia.
Those with debt will have their assets repossessed. The problem will be for the banks, copping the loss to market value, and again in the next round. And the next. They may inflate to disguise, but relative to incomes, it won't cut it. Think Weimar Germany in the '20's.
At the same time, the virtual bits of the CBD activity will be in trouble. The parasite stuff. As will the corporate just-in-time food delivery system. And the charging of profit. And interest. (They both demand growth).
Expect a return to smaller holdings, more folk per acre, better husbandry, less monoculture, triaging of decaying infrastructure, less dog-eat-dog, more pulling-together communities, a re-filling of those empty rural hub-towns, more rail, more public transport, less flying, more electronic communitation.....
Or do you want a list? :)
Here comes the Law.....nowhere to hide for the banking criminals....we're talking US Law.....
http://globaleconomicanalysis.blogspot.co.nz/
Bernie will soon have cellmates by the score!
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