Each unhappy marriage is unhappy in its own way.
- Tolstoy, Anna Karenina
Yesterday, dear readers, we failed you. We went and wrote a long, charming, cutting, and utterly enlightening post about the too-big-to-fail banks, but completely forgot to explain a key point: Why makes these banks too-big-to-fail in the first place?
See, not everyone has bought into this particular bit of dogma. Quite a few smart and well-intentioned people have argued that the best thing to do is leave the banking sector to its dirty fate. Damn the torpedoes! Full speed ahead, and all that.
Here at the Strawman Blogger, we aren’t too fond of that plan. But don’t take our word for it. Instead, let’s have a serious talk about financial crisis, what it means for you, and why we probably don’t want to go and irresponsibly let banks crash down willy-nilly.
Financial Crises – A Case Study
Recessions can be wildly different. They’re a bit like bacteria – there’s one in every shape and form. So Volcker’s recession, brought on as the Federal Reserve crushed inflation with staggering interest rates, was structurally from the dotcom crash, which was a much more conventional asset bubble.
But financial crises are all a little alike. It starts with a liquidity mismatch between someone’s assets and their liabilities, moves to a funding gap, and eventually ends up as systemic contagion. Follow us? Don’t worry. We’ll get you there.
To understand the financial crisis of September 2008, it actually helps to visualize a classic bank run. A typical bank earns money in a simple way. It takes in money through the form of deposits and sends it out in the form of loans. The difference between what it pays on deposits and earns on loans is its profit spread.
Of course, that model poses a few problems for the bank. Most notably, its liabilities are very liquid – people can withdraw their deposits at any time. But its loans are highly illiquid, locked up for anywhere between five and thirty years. Generally, this isn’t a problem. Banks are always careful to keep enough cash on hand to meet the needs of their depositors. But if something changes – if something spooks depositors into withdrawing a lot of money at once – a funding gap appears. Banks can’t redeem their assets quickly enough to meet their liabilities. A bank fails.
And what if the bank failed in such a way that people start to doubt the stability of other banks? They’d respond pretty rationally, by attempting to withdraw their money from similar institutions, which only creates the same problem writ large. A crisis at a single bank becomes a crisis for all banks. A bank run.
Of course, we don’t have bank runs anymore. Largely, that’s down to the FDIC. If a bank fails, the FDIC insures their deposits. More than that, it winds down the bank in an orderly fashion, sell its deposits to another institution, and pays out any bad liabilities from the insurance fund. People no longer have any reasons to withdraw their money because they know their money is protected.
Flash Forward
So we’ve solved the problem of bank runs. Why the Great Recession?
Ah, but it’s a brilliant interesting story. It all started with the rise of the shadow banking system.
A shadow bank is an intermediary. It doesn’t take deposits like a traditional bank. Instead, it channels money from institutional investors to regular businesses – among them, large financial institutions. Big banks.
Now, shadow banks have a peculiar asset and liability mismatch. Each day, they raise a substantial amount of money through the repo market and associated other forms of short-term financing.
This money goes to fund their day-to-day operations. But while their funding is liquid, the investments of a shadow bank tend be highly illiquid – long-term positions in the securities market that are difficult to unwind quickly. Not unlike the deposit versus loan mismatch we detailed above.
When significant questions are raised about a shadow bank’s viability, short-term lenders and the repo market react. Funding becomes more expensive or dries up completely. Investors demand a haircut. If doubts are severe enough, it can affect a shadow bank's ability to continue as a going concern.
And what if investors have similar concerns about other institutions? In unison, they start to get antsy about the repo market. That’s largely what happened after Lehmann collapsed in September of 2008. TED and LIBOR rates shot through the roof, investors panicked, and market liquidity vanished. We remember those days. They weren’t terribly fun.
Further, the liquidity mismatch has systemic implications. A shadow bank can’t passively sit by as its core capital is eroded. Instead, it will attempt to sell its long-term securities position to offset its losses. But when the market is crowded with sellers, it’s forced to discount these assets further, which makes its capital ratios look even worse, which scares even more investors away. And we haven’t even started on mark-to-market rules. It’s all quite a mess.
And size matters. If a shadow bank is large enough, its asset positions can be huge – to the tune of billions and billions of dollars. When this happens, it depresses prices across the system as whole. A large enough institution can set off a panic on its own.
From Wall Street To You
But what does that mean to you? Everything. The trouble doesn’t stay in the shadow banking sector. Since the repeal of Glass-Steagal, the biggest banks in the country also have investment operations. Shadow banking and commercial banking are two sides of the same coin. Pinched between their inability to finance their operations and the pressures placed on their own investment banks, these companies aren’t able to perform their traditional functions.
A bank without liquidity can’t extend new loans. That means that consumer credit collapses, which in turn affects the real market. Auto lenders can’t sell inventory, homes sit unsold. And many businesses, small and large, depend on short-term credit to meet their daily needs. Businesses, too, can have asset-liability mismatches. Invoices take months to redeem; payroll is due every two weeks.
From a shadow bank to a loan to your very own paycheck. Too-big-to-fail matters.
What Is To Be Done
As we said yesterday, it would be quite nice to cut the banking sector down to size. We don’t need reasons for this. We’re powered by our own sense of smugness.
But that’s not enough. As smarter men have mentioned, many small shadow banks can still pose systemic risks. So we’ll need to regulate them better. In the end, we’ll need a resolution authority that looks a lot like the FDIC, with the power to insure transactions on the repo market and wind down failed institutions.
It also might help to re-instate the traditional division between investment and commercial banking. Like Hamlet and his mother, they just don’t belong together.
Cutting the world’s problems down to size. That’s how we roll.
