As Michael S. wrote long ago, American commercial banks do not, as a matter of fact, balance short-term customer deposits with long-term loans:
---
The maturity transformation issue – speaking from my experience as a bank director, and at least at the level of an individual bank – is not quite as easy to identify as the source of economic fluctuation as it might have been in Bagehot’s time. As a matter of fact, well managed banks do not “borrow short and lend long.” Balancing the maturities of deposits and of risk-based assets (i.e., loans) is the central task of what bankers call ‘funds management’. This is an art made much easier today by computerized analysis, so that ordinary bankers can today determine easily about their loan portfolios what a century ago perhaps only the Göttingen-educated mathematical genius J.P. Morgan was able to envision about his.
---
and he says similar things about the 'financial pressure', non-bank finance, and the limited effect of regulation on it once the horse is out of the barn:
---
What has happened in the past few months [of 2008 - C.] illustrates the difficulty of relying upon regulation to stabilize the financial system. Commercial banks were subjected to very stringent regulation in the aftermath of the crash of 1929 and the subsequent depression. Contrary to much of what has been said in the popular news media, very little of this regulation has been removed. Indeed, it has been more added to than reduced for years. However, economic pressure is rather like hydraulic pressure – it leaks through all attempts to contain it, at the points of least resistance. During all this time, an extensive sphere of non-bank lending activity was allowed to develop completely outside the bounds of commercial banking. Because it didn’t fall within the legal purview of bank regulation, it didn’t have to meet standards of capitalization, and its loans didn’t have to be as well collateralized. Leading figures in the non-bank financial sector like Franklin Raines and Angelo Mozilo paid very effective court to politicians like Christopher Dodd and Barney Frank to assure that they were not regulated as strictly as commercial banks. It is a travesty that these politicians are now permitted by the ideologically blinkered news media to scapegoat others for the disaster they themselves were instrumental in causing.
Could one improvement be making bank officers have "more skin in the game"? 2007-8 showed that the lending officers and bank officials got to keep any bonus they made on the bad loans. What if the top 10-20% of bank employees were treated as partners when the bank collapsed, ie all their assets went to making the bail out facility whole. That would temper some of the exuberance to make risky loans. Another possibility would be requiring that part of the BOD be jailed after a failure that required a bailout. Again, no one went to jail after 2007. The problem seems to be socializing losses and privatizing gains.
Fair enough. Part of my question is that I saw bank officials whose lending caused bank failures escape unscathed while businesses who were viable but whose loans were not rolled over (? Minskey issue) fail. Was the unlimited bailout of SVB necessary or just adding to moral hazard? If the execs of SVB and the SF regulator were jailed or lost wealth than maybe the moral hazard is lessened. Everything is a tradeoff (I did read the other essay)
To clarify, I'm pretty sure it is incorrect to say svb was bailed out. Depositors were made whole. Very different. And that is very different from clawback from bank personnel or jailing them. I think whether depositors above the limit should have been made whole is your best question. I share your implied skepticism on that one but IDK.
The system would be in better shape if regulators (Private? Why not?) pushed banks to make variable rate loans and back variable rate mortgages. That was the essence of the SVB problem. They had long term FIXED RATE assets.
I heard recently that few or no other countries have fixed rate 30 year mortgages. I think it was Canada that had 10 year fixed rates and most or all of Europe was shorter. Of course, Sowell's law applies to this.
I believe that Canada's mortgage rates are fixed for only 5 years, and Canada 's financial system is much more robust than ours (but smaller, also). The 30-year fixed rate was the U.S. government's "solution" to the foreclosures of the 1920s and 1930s, but it has been a source of financial fragility ever since.
It seems to me that private insurance would have many of the same harmful incentives and at least a couple new ones. It's not at all clear to me it would be a net gain. On top of that is the issue of whether private insurance could possibly have enough resources to be able to cover failure of the largest banks. It seems the government would still be the final backstop and the insurance companies would have the same perverse incentives as insured banks but on an even grader scale.
from your paper - "Ideally, policymakers would incentivize banks to take only the right risks at the right time. Given recent events, it's become clear that the current system does not foster such behavior."
What is the "right risk"? Sounds a bit oxymoronic. Risk implies the outcome is not always success.
... You acknowledge this when you later mention prudent risk but that still leaves the question of which risks are prudent. We can have metrics to estimate but even you have on multiple instances commented on how a local banker might have knowledge that allows them to better evaluate customer loans and the accompanying risks such that it is difficult to sell these loans without great loss. Given that, how does one determine what risks are "right"?
The financial services industry lobbied long and hard to undermine Glass-Steagall. Wall Street and national commercial banks is a marriage made in hell. Now the industry is highly concentrated (big banks' share of deposits, an ever smaller number of bulge-bracket firms) too. This is an industry, like so many others, ripe for trust-busting.
“The United States has since its founding been characterized by populist hostility toward the banking industry. Until late in the 20th century, banks were not allowed to have branches in more than one state, and many states limited the number of branches that a bank could have. In some states, that limit was one.”
Actually, the Second National Bank of the United States, headquartered in Carpenter's Hall, had branches throughout the nation. And state chartered banks generally required a legislative act which presented opportunity for corruption. State banking regulation had as much to do with establishment legislator graft as it did with any “populist hostility” so much so that “populist hostility” seems like an unsupportable red herring to whitewash an establishment tradition of corruption. Moreover, state banking regulation tended to modeled after the national banking acts enacted under Lincoln and Johnson.
Indeed, populism has in some cases been quite supportive of banking. For example, the great populist Liberal Party Prime Minister William Gladstone, popularly known as “the people’s William” in 1861, then serving hancellor of the Exchequer was instrumental in establishing the Postal Savings Bank, the first postal banking system in the world, a system that gave large segments of the British population that did not have access to the banking system. As an echo of that great achievement, one might point to the much beloved by his people Prime Minister of India, Prime Minister Narendra Modi who set in motion a banking scheme to grant access to banking services to hundreds of millions of his fellow citizens who were then lacking such access.
For those reasons, one might argue that there is nothing inherently hostile to banking in populism.
I’m not well educated on banking so forgive me if this is a naive question but why do we let banks lend at all? Couldn’t they hold deposits as custody assets like brokerages do? They would make money on the spread between your checking account and treasuries/repo, they could lend against the assets with the corresponding limitation on customers using the assets, or charge fees if interest rates are too low. Then lending (beyond asset based) would move to other players who raised longer term non-callable money. It seems so simple so it must be wrong. What am I missing?
In my last paragraph, I suggested reading an essay of mine before commenting. There you would have found, along with other helpful explanations,
"Why don't we, as depositors, keep our deposits and invest them ourselves? The most obvious reason is that the bank employs dedicated experts to manage the risk of lending, meaning it does a better job at selecting and managing investments than we could on our own. But a more fundamental reason is that banking reduces the risks associated with lending. Our deposits, individually speaking, are short term, and are therefore risky for the bank to hold as liabilities. But when considered as a collective, they become less risky long-term liabilities, since we do not all withdraw our deposits at once. By pooling our deposits, banks reduce the risk they might otherwise incur by taking on just a handful of short-term liabilities.
Banks reduce risk further by pooling their loans. A diversified portfolio of loans is less risky than any single loan. And because different loans pay off on different dates, diversification across time ensures that interest-payment flows into the bank are steady."
I did read the paper before commenting and my point is a little different. Why not just have a narrow bank that doesn't do lending and leave lending to other institutions that raise money for institutional or other investors. I don't see how I as an individual depositor get much benefit from having my deposits lent. If it's just a little fee reduction and 50 bps, wouldn't it just make more sense to pay a fee.
Then you get a decline in lending and a corresponding reduction in business activity and/or an increase in gaming the system by having non-banks incur risk and transfer it to banks. But I'm repeating myself.
Who cares if the risk is transferred? Depositors assets are in custody. The banks don't own them. They just lend against them as a brokerage does or charge fees for providing banking services. I take the point on the reduction in lending but why wouldn't more investors and private credit options move into the space the banks vacate? To answer my own question, if the money wasn't rehypothicated then overall money supply gets reduced so the private sector investors couldn't make up for that.
As a thought experiment, one can imagine there are two financial institutions.
Let's call the first institution a "stock and flow". You deposit your money there and they don't mess with it, so, even more narrow than narrow because they can't even buy bonds with it, and they don't pay interest. They just hold it in the account and provide you with access to the transaction system, for reasonable fees.
The second type of institution is "the loaning company". It makes loans. It needs capital, and it can raise it from the market, but, if by debt, then it must offer yield: market-clearing rates of risk-adjusted returns, or if by equity, market rates of expected dividends and appreciation. The attraction of the yield pulls "cash" out of "storage" and into "investment", but the yield offered can only go so high, the expected rate of return of the whole loan pool minus expenses and enough profit for a market rate of return.
I am not persuaded that the merger of these institutions actually results in more lending while holding risks constant. To the extent there would be more lending, there would be more risk.
As Michael S. wrote long ago, American commercial banks do not, as a matter of fact, balance short-term customer deposits with long-term loans:
---
The maturity transformation issue – speaking from my experience as a bank director, and at least at the level of an individual bank – is not quite as easy to identify as the source of economic fluctuation as it might have been in Bagehot’s time. As a matter of fact, well managed banks do not “borrow short and lend long.” Balancing the maturities of deposits and of risk-based assets (i.e., loans) is the central task of what bankers call ‘funds management’. This is an art made much easier today by computerized analysis, so that ordinary bankers can today determine easily about their loan portfolios what a century ago perhaps only the Göttingen-educated mathematical genius J.P. Morgan was able to envision about his.
---
and he says similar things about the 'financial pressure', non-bank finance, and the limited effect of regulation on it once the horse is out of the barn:
---
What has happened in the past few months [of 2008 - C.] illustrates the difficulty of relying upon regulation to stabilize the financial system. Commercial banks were subjected to very stringent regulation in the aftermath of the crash of 1929 and the subsequent depression. Contrary to much of what has been said in the popular news media, very little of this regulation has been removed. Indeed, it has been more added to than reduced for years. However, economic pressure is rather like hydraulic pressure – it leaks through all attempts to contain it, at the points of least resistance. During all this time, an extensive sphere of non-bank lending activity was allowed to develop completely outside the bounds of commercial banking. Because it didn’t fall within the legal purview of bank regulation, it didn’t have to meet standards of capitalization, and its loans didn’t have to be as well collateralized. Leading figures in the non-bank financial sector like Franklin Raines and Angelo Mozilo paid very effective court to politicians like Christopher Dodd and Barney Frank to assure that they were not regulated as strictly as commercial banks. It is a travesty that these politicians are now permitted by the ideologically blinkered news media to scapegoat others for the disaster they themselves were instrumental in causing.
---
I have collected all Michael S.'s excellent comments on money and banking and posted them on my old blog here: https://candide3.wordpress.com/2020/04/15/some-old-ur-comments-by-michael-s-on-money-and-banking/
Could one improvement be making bank officers have "more skin in the game"? 2007-8 showed that the lending officers and bank officials got to keep any bonus they made on the bad loans. What if the top 10-20% of bank employees were treated as partners when the bank collapsed, ie all their assets went to making the bail out facility whole. That would temper some of the exuberance to make risky loans. Another possibility would be requiring that part of the BOD be jailed after a failure that required a bailout. Again, no one went to jail after 2007. The problem seems to be socializing losses and privatizing gains.
More skin in the game, yes. Which means more equity capital that is all lost when a bank goes bankrupt, like SVB.
The 2008 bailouts that were terrible were because the equity owners of the bailed out firms lost so little
It's not at all clear that's an improvement. Likely to mean less bad loans and less failures but at what cost?
Fair enough. Part of my question is that I saw bank officials whose lending caused bank failures escape unscathed while businesses who were viable but whose loans were not rolled over (? Minskey issue) fail. Was the unlimited bailout of SVB necessary or just adding to moral hazard? If the execs of SVB and the SF regulator were jailed or lost wealth than maybe the moral hazard is lessened. Everything is a tradeoff (I did read the other essay)
To clarify, I'm pretty sure it is incorrect to say svb was bailed out. Depositors were made whole. Very different. And that is very different from clawback from bank personnel or jailing them. I think whether depositors above the limit should have been made whole is your best question. I share your implied skepticism on that one but IDK.
Nice write-up. Thank you for sharing my post as well. It was great to read your perspective on the market.
The system would be in better shape if regulators (Private? Why not?) pushed banks to make variable rate loans and back variable rate mortgages. That was the essence of the SVB problem. They had long term FIXED RATE assets.
I heard recently that few or no other countries have fixed rate 30 year mortgages. I think it was Canada that had 10 year fixed rates and most or all of Europe was shorter. Of course, Sowell's law applies to this.
I believe that Canada's mortgage rates are fixed for only 5 years, and Canada 's financial system is much more robust than ours (but smaller, also). The 30-year fixed rate was the U.S. government's "solution" to the foreclosures of the 1920s and 1930s, but it has been a source of financial fragility ever since.
In the UK the maximum you get is 10 year fixed and anecdotally, few people do this, 3-5 years is more common.
It seems to me that private insurance would have many of the same harmful incentives and at least a couple new ones. It's not at all clear to me it would be a net gain. On top of that is the issue of whether private insurance could possibly have enough resources to be able to cover failure of the largest banks. It seems the government would still be the final backstop and the insurance companies would have the same perverse incentives as insured banks but on an even grader scale.
from your paper - "Ideally, policymakers would incentivize banks to take only the right risks at the right time. Given recent events, it's become clear that the current system does not foster such behavior."
What is the "right risk"? Sounds a bit oxymoronic. Risk implies the outcome is not always success.
... You acknowledge this when you later mention prudent risk but that still leaves the question of which risks are prudent. We can have metrics to estimate but even you have on multiple instances commented on how a local banker might have knowledge that allows them to better evaluate customer loans and the accompanying risks such that it is difficult to sell these loans without great loss. Given that, how does one determine what risks are "right"?
The financial services industry lobbied long and hard to undermine Glass-Steagall. Wall Street and national commercial banks is a marriage made in hell. Now the industry is highly concentrated (big banks' share of deposits, an ever smaller number of bulge-bracket firms) too. This is an industry, like so many others, ripe for trust-busting.
“The United States has since its founding been characterized by populist hostility toward the banking industry. Until late in the 20th century, banks were not allowed to have branches in more than one state, and many states limited the number of branches that a bank could have. In some states, that limit was one.”
Actually, the Second National Bank of the United States, headquartered in Carpenter's Hall, had branches throughout the nation. And state chartered banks generally required a legislative act which presented opportunity for corruption. State banking regulation had as much to do with establishment legislator graft as it did with any “populist hostility” so much so that “populist hostility” seems like an unsupportable red herring to whitewash an establishment tradition of corruption. Moreover, state banking regulation tended to modeled after the national banking acts enacted under Lincoln and Johnson.
Indeed, populism has in some cases been quite supportive of banking. For example, the great populist Liberal Party Prime Minister William Gladstone, popularly known as “the people’s William” in 1861, then serving hancellor of the Exchequer was instrumental in establishing the Postal Savings Bank, the first postal banking system in the world, a system that gave large segments of the British population that did not have access to the banking system. As an echo of that great achievement, one might point to the much beloved by his people Prime Minister of India, Prime Minister Narendra Modi who set in motion a banking scheme to grant access to banking services to hundreds of millions of his fellow citizens who were then lacking such access.
For those reasons, one might argue that there is nothing inherently hostile to banking in populism.
I’m not well educated on banking so forgive me if this is a naive question but why do we let banks lend at all? Couldn’t they hold deposits as custody assets like brokerages do? They would make money on the spread between your checking account and treasuries/repo, they could lend against the assets with the corresponding limitation on customers using the assets, or charge fees if interest rates are too low. Then lending (beyond asset based) would move to other players who raised longer term non-callable money. It seems so simple so it must be wrong. What am I missing?
In my last paragraph, I suggested reading an essay of mine before commenting. There you would have found, along with other helpful explanations,
"Why don't we, as depositors, keep our deposits and invest them ourselves? The most obvious reason is that the bank employs dedicated experts to manage the risk of lending, meaning it does a better job at selecting and managing investments than we could on our own. But a more fundamental reason is that banking reduces the risks associated with lending. Our deposits, individually speaking, are short term, and are therefore risky for the bank to hold as liabilities. But when considered as a collective, they become less risky long-term liabilities, since we do not all withdraw our deposits at once. By pooling our deposits, banks reduce the risk they might otherwise incur by taking on just a handful of short-term liabilities.
Banks reduce risk further by pooling their loans. A diversified portfolio of loans is less risky than any single loan. And because different loans pay off on different dates, diversification across time ensures that interest-payment flows into the bank are steady."
I did read the paper before commenting and my point is a little different. Why not just have a narrow bank that doesn't do lending and leave lending to other institutions that raise money for institutional or other investors. I don't see how I as an individual depositor get much benefit from having my deposits lent. If it's just a little fee reduction and 50 bps, wouldn't it just make more sense to pay a fee.
Then you get a decline in lending and a corresponding reduction in business activity and/or an increase in gaming the system by having non-banks incur risk and transfer it to banks. But I'm repeating myself.
Who cares if the risk is transferred? Depositors assets are in custody. The banks don't own them. They just lend against them as a brokerage does or charge fees for providing banking services. I take the point on the reduction in lending but why wouldn't more investors and private credit options move into the space the banks vacate? To answer my own question, if the money wasn't rehypothicated then overall money supply gets reduced so the private sector investors couldn't make up for that.
As a thought experiment, one can imagine there are two financial institutions.
Let's call the first institution a "stock and flow". You deposit your money there and they don't mess with it, so, even more narrow than narrow because they can't even buy bonds with it, and they don't pay interest. They just hold it in the account and provide you with access to the transaction system, for reasonable fees.
The second type of institution is "the loaning company". It makes loans. It needs capital, and it can raise it from the market, but, if by debt, then it must offer yield: market-clearing rates of risk-adjusted returns, or if by equity, market rates of expected dividends and appreciation. The attraction of the yield pulls "cash" out of "storage" and into "investment", but the yield offered can only go so high, the expected rate of return of the whole loan pool minus expenses and enough profit for a market rate of return.
I am not persuaded that the merger of these institutions actually results in more lending while holding risks constant. To the extent there would be more lending, there would be more risk.