Banking safety in a crisis
How to find a bank that will stand through the rough times?
From Tuomas Malinen’s Forecasting Newsletter
Bank is an exceptional entity in the corporate world in many ways. Its product is a financial contract (debt) and it can create money out of ‘thin air’. There are a wide variety of misconceptions concerning banks and banking crises.
In this entry, I will detail why banks are inherently fragile due to their very nature and what characteristics you want a bank to have so that it can be considered safe. This entry also acts as an introduction to bank safety metrics we have constructed and will continue to develop. We have just published a list of the most-safe U.S. banks.
What is a bank?
This excerpt from a book I am writing on forecasting financial crises, comparing a bank to a tractor company, should make the difference between a bank and a normal corporation very clear.
Bank is an exceptional entity in the sense that while, for example, the output of a tractor company is tractors, the output of bank is debt. This makes the bank something of an anomaly in the corporate world. It follows the same accounting principles than any other corporation, but its output is a financial contract (debt). Commonly, this debt is given out as an IOU meaning that the bank gives a promise that whatever sum you deposit there, you get it back whenever you want making (a contractual warranty of short).1 In addition to deposits, this bank debt can be in the form of bonds, derivatives or inter-bank funding the bank has obtained from inter-bank markets. These are all liabilities to a bank, over which the holders have a claim.
This means that, because the output of a bank are debt contracts (deposits, bonds, etc.), their holders, i.e., customers can either claim or sell them at will. With the tractor company, customers naturally hold no such power over the production of tractors. The company will produce the tractor with its own timetable and customers cannot claim them to themselves before the tractor is finished (unless something else is agreed upon).
However, a bank can face a situation, where most of its customers can demand a very rapid repayment of the "production" (debt) they hold. That is, with a bank the claiming back of “production” can occur in multitude of ways as normal business transactions. This is why bank is such an exceptional entity and why the very structure, or the business model, of a bank makes it prone to a run.
The process of a bank run
Depositors can transfer their money digitally to other financial institutions or to assets or they can exchange their deposits into cash. If a large share of customers demand this at the same time, there will be a run on the deposits of a bank, where it faces a risk of running out of liquidity (assets to convert into money) causing the bank to fail. If the run on deposits is large enough, the bank will fail regardless, because its business model (taking deposits as a collateral for loans) fails. This is what happened, e.g., with the Silicon Valley Bank.
Holders of other forms of bank debt can sell their stocks and bonds en masse crashing their value. In the worst case, this leads to a collapse in the value of the equity of the bank pushing it into insolvency. Other banks can refuse to lend money to the bank in the inter-bank markets, and possibly demanding immediate payback of inter-bank loans, which will threaten the solvency of a bank, because it cannot obtain short-term loans to cover its acute liquidity needs (expect from a central bank). This all can also occur "overnight".
Depositors can issue claims to collect their deposits, while holders of stocks and bonds of a bank can issue selling orders at any hour. In practice, deposits will be transferred to another bank or turned into cash only, when the bank is open, while bonds and stocks will be sold only when markets are open. Still, the claim or the selling order can be made digitally at any hour for most of the bank debt.2
With any other form of company, with the possible exception of asset management companies, this cannot occur without some major violent external event. With the tractor company, for example, the only thing destroying its production in totality (in an "instant") would be an event, which destroys its factory, like an earth-quake or a fire. However, with a bank, such a destruction can occur in normal business transactions, which volume just becomes over-whelming. Essentially, the whole "production" of a bank can collapse in a very short period of time.
Banking safety
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