Banking safety in a crisis
How to find a bank that will stand through the rough times? (Free)
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
The stability of a bank during normal times depends on its credibility, that is, trust of its customers that it can uphold its financial pledges (pay back different forms of bank debt on time). During the times of financial crises, both the trust of investors and other banks to a bank, and the ability of it to withstand a run on its deposits, determine whether the bank will fail or not.
To be more precise, a bank fails in a depositor run, when it does not have enough liquid assets to convert into money to pay for the outflow of deposits or that the run on deposits simply breaks the business model of a bank. In an investor run, a bank fails, when the value of its equity collapses due to heavy selling of its stocks and bonds. Alas, whatever factor breaking the trust of majority of bank customers can lead the bank to fail. If trust evaporates with multiple banks simultaneously, or in contagious manner, a systemic event, a banking crisis emerges.
The most crucial point for a banking safety, is its ability to withstand a run on its deposits. This means that that a bank has sufficient liquid assets to cover for the outflow of deposits. These ‘assets’ can be in the form of cash, securities and collateral eligible for a loan from the central bank. This can be measured with liquidity to deposit ratio of a bank. Liquidity to deposit ratio, or share, of 1 (or 100%) or above would naturally be optimal, but often times not all depositors run to the bank (see, for example, my earlier piece going through deposit outflows in some historical runs).
Based on historical data, e.g., from the runs during the Great Depression we can consider the deposit/liquidity ratio of 0.6 as a threshold for a “safe bank”. Outflow of deposits beyond 60% also usually implies that the business model of the bank fails, which means that no amount of liquidity can be able to save it. The simply is no bank left to run anymore.
In our first set of banks assumed safe, we have used the 0.6 liquidity/deposit ratio to root out those U.S. banks, which can be considered unlikely to fail in a banking crisis. However, this is not a perfect metric with for example composition of deposits playing a role. This is because retail, i.e., consumer deposits tend to be more stable, because households tend to have smaller deposits than corporations, which means that a larger portion of retail deposits need to face a run to break a bank. Households also tend to have a more close (personal) relationship to a bank, which implies that they are less likely to suddenly lose trust to the bank than corporations. However, in general, when bank runs spread, the difference between retail and corporate depositors becomes negligible.
We will keep on going through research on bank runs and analyzing the U.S. bank data to provide more comprehensive metrics to assess the risk of a bank failure. In the meantime, if you live or have deposits in the U.S., I urge you to go check our list on the most safe U.S. banks.
Disclaimer:
The information contained herein is current as at the date of this entry. The information presented here is considered reliable, but its accuracy is not guaranteed. Changes may occur in the circumstances after the date of this entry and the information contained in this post may not hold true in the future.
No information contained in this entry should be construed as investment advice. Readers should always consult their own personal financial or investment advisor before making any investment decision, and readers using this post do so solely at their own risk.
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This means that the bank guarantees that the amount of money you have deposited there, or the facts of your deposit agreement, are "true".
This does not necessarily apply to long-term bank debt, like time-deposits.