The Banking Crisis - Why It Will Happen Again

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by: Atle Willems, CFA
Summary

Banks are always at the centre of large-scale economic bubbles and crisis.

This is not by chance, or induced by some shock, but by design.

In this article, I set out the key reasons why banks fail and why they will necessarily fail again.

At the end of the 1990s and early 2000s we had the dot-com and telecoms bubbles. Later on that decade we had the housing bubble. To many, these bubbles might appear as totally separate and unrelated events that had little in common other than being asset bubbles.

However, these bubbles had at least two things in common. Firstly, they popped. Secondly, there was one major player to be found at the center of it all; the banking system.

This system will also be at the very center of the next crisis since the economy comes to a halt when it fails. And fail it will. In this article I discuss why.

Why banks fail...

The banking system, with the elastic currency it supplies to the market, ensures the economy at large finds itself almost continually in a state of crisis. Domestic- and cross-border (preemptive) crises meetings, ever new regulations imposed on banks and the financial industry, bail-outs, bail-ins, and state (partial) takeovers of banks and non-banks, are all evidence of economies in a situation of more or less constant crisis.

Banks regularly run into financial problems not by some fault of the free market, by coincidence, or due to a "shock" of some sort, but by design. Fractional reserve banking is inherently unsound from the very beginning. While sound money such as gold is valuable in other uses as well and requires investments and effort to increase its supply, today's fiat money has no intrinsic value whatsoever; its only value comes from being widely accepted as payment in transactions.

Nor do the currencies employed around the world today require any previous sacrifice for the issuance of new ones; banks and central banks can effortlessly increase its quantity with a few touches on a computer keyboard. Similarly, they can decrease its quantity just as effortlessly. This is in stark contrast to inelastic currencies which tends to increase only slowly and gradually, but never decline (e.g. money backed by precious metals).

We here arrive at a key problem for the banking system with the money employed today, namely that the market values of bank assets which "back" the deposit liabilities are themselves dependent on continued issuance of additional credit, i.e. an increase in the quantity of money. Why? Because the previous issuance of money by banks inflated the market values of the financial assets (USTs, MBSs etc.) and the value of the collateral that support the loan portfolios. Additionally, many businesses dependent on credit to operate will require renewed and additional credit in the future, a process which helps create the business cycle (see the Austrian theory of the business cycle for more on this).

Bank credit cannot however forever expand without setbacks. And absent interventions from the central bank, the market prices of bank assets will decline relative to other prices when bank credit declines. How come? Because just as bank credit growth previously helped inflate those bank asset prices relative to other items (e.g. consumer goods prices, wages and salaries), credit contraction will now act to deflate them. Alas, whenever bank credit contracts or slows down, banks sooner or later run into financial problems as bank equity shrinks relative to liabilities.

The irony of it all is that what previously amassed profits for banks (credit expansion) now is what can trigger their demise (credit contraction). Banks therefore depend on ongoing monetary inflation to keep the market values of their securities- and loan portfolios constantly inflated. This is the primary reason central banks unanimously pursue inflationary monetary policies as banks (with fractional reserve banking), would otherwise fail.

The fragility of fractional reserve banking, most notably during times of deflation, manifests itself in three core areas for banks (all of whom are closely related):

  • Deficient reserves: only a small fraction of deposit liabilities are kept as reserves
  • Asset-liability duration mismatch: long term assets (loans) are largely financed by short term debt (deposits)
  • Highly leveraged: banks are financed with very little equity in proportion to assets

Any provocation of the first two items will swiftly reveal the underlying financial weakness of a bank.

The inherent illiquidity will become evident once a large enough proportion of depositors attempt to withdraw their funds as would be the case during a classic bank run (customers run to the bank to withdraw cash) or during an electronic bank run (when customers transfer their deposits electronically to another bank, or when other banks squeeze the troubling bank). Problems will also be revealed when delinquencies rise and borrowers default, an inevitable consequence of bank credit expansion.

The duration mismatch between assets and liabilities also presents ongoing challenges for banks. Firstly, the market values of bank assets and collateral positions fluctuate while its liabilities are largely fixed and redeemable at par. A fall in the value of assets and collateral can therefore wipe out a bank's equity. Secondly, a significant portion of the assets are fairly illiquid and hence cannot be quickly converted to cash should the need arise.

This inherent illiquidity is not (necessarily) caused by rogue bank management, but is instead a direct reflection of how the banking system is designed: when a loan is issued, the bank records an asset on its balance sheet (the loan, which is typically longer term) and a liability (the deposit, which the borrower can withdraw at any time). The duration mismatch is therefore created at the very onset.

Combined, these balance sheet weaknesses mean banks are constantly at the mercy of not only depositors, but also of other banks. If one bank fails, other banks may also fail as they likely have some exposure to that bank either directly or indirectly. But they fail not because other banks are unsound, but because they themselves are financially unsound. This is why banks regularly fall like dominoes.

It must also be added that banks are ever-dependent on market confidence, economic stability, and, as previously explained, rising prices which the banks themselves help spur through bank credit growth. But, as banks are themselves the creators of economic instability, it should be obvious why banks always find themselves at the center of financial crises: most financial crises originate within the banking sector itself. Financial- and economic crises are therefore almost always in fact banking crises.

...and why banks will fail again.

Banks will fail again because the inherent problems with banking discussed above have neither been addressed fully nor solved. Most banks around the world still operate as very fractional reserve banks (see here for a useful overview). The Basel Accord may have led to slight improvements in certain areas of bank balance sheets, but they are too small to mention and arguably largely irrelevant as they address symptoms rather than the fundamental problems with the banking system as a whole; fractional reserves, insufficient capital to weather a storm, and banks ability to create new money when they grant credit.

Gratuity of the three rounds of QE, the reserve position for U.S. banks improved dramatically during the 2008/9 banking crisis and in the aftermath (though the required reserve ratios have not changed much).

But to the extent securities can still be readily exchanged for cash from the Federal Reserve during times of financial distress, bank balance sheets have improved substantially less impressively based on the ratio of reserves and securities to total deposit liabilities. Today, this ratio stands at around 49%. This compares to an average of about 40% for the period spanning 1995 to 2005.

Though U.S. banks have become more liquid, the capital position remains lackluster. In fact, the ratio of equity to total deposit liabilities, a key capital ratio for banks in my book, has actually deteriorated since 2008. On the eve of the banking crisis (Sep '08), the ratio stood at almost 17%. Today, it has dropped to just above 15%, a 13 year low.

So, though U.S. banks have become more liquid, they are today even more poorly capitalized relative to deposit liabilities than they were prior to the banking crisis almost nine years ago.

At the time of writing, there appears to be little financial distress for U.S. banks, at least when based on a few key indicators; LIBOR remains relatively low and stable (though higher due to Fed rate hikes), reverse REPOs remain high, while REPOs and discount borrowings remain at or near zero.

But with interest rates on the rise and bank credit growth declining, we once again seem to be entering another testing period for U.S. banks. If bank credit growth continues to decline as it now has since October last year, the inherent weaknesses of bank balance sheets will increasingly be exposed and the risks of yet another banking crisis will increase accordingly. With stock market valuations still near record highs, a stock market correction could speed up the whole process.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.