What are Banks and Why do They Collapse?
TL;DR It looks extremely complicated, that's by design. Your money probably isn't where you think it is, and that probably isn't an issue.
Banks are essential. They are the institutions that control the storage and flow of economic energy (money), enabling the flow of local, national, and global commerce. They are the gatekeepers who decide who gets credit (the money you need, don’t have, and are about to borrow) and who does not.
How Long has there Been Banking?
First principles start with understanding the history of a topic. Banking is one of the world’s oldest businesses. Records show that the practice of banking (previously known as money changing) took place in the ancient Middle East. Grain would be loaned to farmers and they would repay the interest in seed weight.
Things like contractual terms, interest, and maturity dates, were being written about in Babylon as far back as 1792 BCE. Gold was introduced as the common medium of exchange to put an end to the bartering system.
The reasons necessitating a universal medium of exchange in order to grow beyond 1-1 commerce are discussed (here).
Over the course of the next 1000+ years this tradition was carried on, occasionally amended, derided, marketed, loved, hated, relied upon … that’s a lot of mixed feelings for something that plays a central role in our lives.
So I gave them my money… What do they do with it?
Great question! When you give banks your money, it is NOT the same thing as asking a friend to hold your wallet while you tie your shoes. The displayed balance on your bank app is nothing more than an IOU and a promise that when you want your money back, they will give it to you. That money goes somewhere. Where does it go? It goes into loans, stock trades, dividend payments to investors, and other commercial activities that the bank engages in, mostly with depositors' money.
Banks use depositors' money to loan money out to individuals and corporations as credit. This credit is then used to build wealth for those individuals (because it allows them to undertake commercial activities) and for the banks themselves (because they get to collect interest on the debt, force assets turnover in the event of default, and charge various fees).
But if Banks have all this money, why have I been hearing about them collapsing?
Importantly, this news has been coming out of the United States and Switzerland. Credit Suisse has long been the black sheep of the banking industry. It financed terrorism, drug dealing, tax evasion, and its destruction is a long term blessing for the world economy.
The American banks have a slightly different story. US banking regulations allow for significant interplay between the business units that underwrite new stocks, commit to risky loans, make investments, and hold depositors' money. This means that when a bank suffers huge losses like Signature, First Republic, and Silicon Valley Bank did due to spiking interest rates that they weren’t ready for, customers will run to the bank and withdraw or transfer as much as they can. Banks are ready for this to an extent, but if the crisis reaches a critical mass, the bank will no longer be able to make payments on its obligations (think of it like defaulting on a thousand credit cards at the same time).
At this point, the bank is no longer able to cover the IOUs mentioned earlier, and they collapse.
The reason this happens is that banks are allowed to leverage their reserves. Basically, this means they can make loans using more money than they really have on hand - often at a 5:1 ratio. Inventing new dollars is a privilege reserved for chartered banks (they literally make up this new asset class worth 5x their cash reserves and make loans using it in dollars; it’s crazy). These magic beans have no actual value, however, which is why the institution collapses when too many people want their actual dollars back.
This whole system is held together, and I'm not kidding, by the power of faith. This is why whenever one bank fails, politicians in many countries get on the news and start praising the stability of the banking systems in their countries. As long as everyone believes they will get their deposits back, the system is the credit engine that turns the wheels of the world. When people stop believing, everyone takes what they can and runs for the hills. This is exactly what happened in the 2008 recession.
How do I keep my money safe from this nonsense? It’s Mine!
Most individuals don’t really need to worry at all. In the United States the FDIC guarantees regular people’s deposits up to $250,000 USD. The CDIC performs the same function in Canada for deposits up to $100,000 CAD.
The good news for Canadians is that we have five huge national banks that face no outside competition and are deeply regulated. Their underwriting, retail banking, and insurance business units are all separate entities with limited exposure to one another, meaning that one can go bankrupt without collapsing the entire company.
For those with more than $100,000 CAD in cash, investments can help keep your money safe. Passive income vehicles, like the ones described in the article below, are a good option.
BTW, I know $100k in deposits may sound unrealistic, but it's still something to keep in mind, especially if you have a joint account with a spouse. In any case, ETFs, stocks, bonds, and other relatively safe assets can help keep your large sums of cash secure when the banking system appears uncertain.
How do I know if a Particular Bank is Safe?
This is a really important question to ask if you have a second citizenship (or plan to immigrate) and want to open an account in another country. While reporting standards vary from country to country, Basel III (which is basically a big international banking agreement) standardizes two ratios that provide a pretty firm idea.
The Capital Adequacy Ratio compares the total amount of money that a bank owes to all of its creditors (which includes depositors like you) and the amount of High Quality Liquid Assets (things that it can sell to turn into cash very quickly) that it possesses. Since 2008 this ratio has fluctuated in Canada from 12.22% to a recent high of 17.3%. If everyone went to get their money back at the same moment, the bank could only cover 17.3 cents for every $1 outstanding. In Canada, each separate business unit of a bank has a different CAR, so the headline figure can make it appear riskier than it actually is.
The Liquidity Coverage Ratio looks at a hypothetical scenario where an extreme market shock affects a bank for 30 days, and cash inflows go to zero. It determines if the bank has enough High-Quality Liquid Assets to cover these outflows. In Canada, banks have been mandated to have an LCR of over 100% since 2009, making them extremely resilient to short-term crises and promoting a more conservative posture. In general, the higher the LCR, the safer the bank is.
Final Thoughts.
The financial system is incredibly vast and intricate, with deep interconnections, and today's standards are informed by past crises. A fundamental law of nature states that increasing complexity and interdependence without also increasing redundancy weakens systems. Since 2008, the guardians of this system have been highly vigilant in ensuring its stability. However, their power is limited by human fallibility and the indelible force of greed, which drives much of the instability. This has been an introduction to one small but crucial aspect of a much larger, ancient, and powerful system that is not understood by the public proportional to its daily impact.
Below I have included a YouTube video by Johnny Harris that provided much of the inspiration for this post.
I hope you’d enjoyed this edition of Young Daily Finance!
Sincerely,
James R. Davies