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Why Banks Fail

By James H. Nolt

Last week I promised to talk about capitalism this week, but I will postpone that to discuss why banks fail. Two events prompted the change. One was an article in Monday’s Wall Street Journal, “China Shadow Lender’s Woes Have Wide Effects,” (p. C1) about the strains on a major “shadow bank” in China. The other was an interview I did for Hong Kong TV yesterday about the financial problems in China.

I use the term “banks” here quite loosely to represent financial companies more broadly. Many firms not called banks do business similar to that of banks, including what are called “shadow banks” in China and elsewhere.

Broadly speaking, there are two ways banks make money. Economics textbooks typically emphasize only one of them: taking deposits from the public in order to make loans. The other is often more important, which is facilitating financial transactions or selling financial products for a fee. Brokers do this as well. Furthermore, many banks that originate loans do not rely primarily on deposits as their source of funds. Today I will focus on the first category of banking business, which economists most emphasize.

The main problem with the loan business is that loans are typically illiquid and long-term relative to the bank’s source of funds, which is more typically call money. Deposits by the public are one form of call money. We do not think of it this way, but in effect when we deposit money in a bank, we are loaning the bank our money. In return for the loan, the bank pays us interest. This is a “call loan,” meaning that we can call for our money back at any time with no advance warning to the bank. The bank, to remain solvent, must be able to honor the calls for funds by its depositors whenever they wish to withdraw them.

Alternatively, a bank’s source of funds might be short-term loans from other banks or by issuing bills in “money markets,” today often including overnight borrowing using repurchase agreements. Such short-term loans for the safest financial institutions are usually charged the lowest commercial interest rate available, such as the London Interbank Offer Rate (LIBOR). Riskier financial companies pay more.

The chronic risk of the banking business is that their sources of funds may become wary if there is doubt about the viability of the long-term assets (mostly loans) with which the bank earns its income (other than fees). Either depositors or other creditors of the bank may have reason to suspect that its assets are falling in value, usually because of rising loan default rates. This is called a solvency crisis.

Alternatively, even a solvent bank can fail during a general financial crisis when the bank’s depositors or lenders have some other more urgent uses of funds and no longer wish to loan them to or deposit them in the bank. This often happens during a financial crisis when there is a rush to liquidity since many individuals and businesses suddenly need more cash to pay immediate obligations and credit is tight. This is called a liquidity crisis.

Typically what government regulators try to do in a crisis is determine which banks are truly insolvent, in which case they might be allowed to fail or be taken over by the government or another bank, and which are just illiquid, in which case emergency loans from the central bank should stabilize them.

Monday’s Wall Street Journal mentioned a case in China today of a large investment company in trouble; this sounds like so many cases in history. Like so many bullish financiers, the company grew fast by attracting deposits by paying higher interest rates. This sounds great for consumers, who are otherwise disadvantaged by the low interest rates they earn on their savings in the government-owned banks. However, history shows many instances of such a bullish strategy failing eventually.

The reason is that bullish financiers compete to attract the most deposits by offering higher and higher rates. Deposits flow to those paying the most for them. However, banks can only pay a lot by earning a lot with the money they “borrow” from depositors. As they grow bigger, it is often harder to find enough ways to invest funds that earn the very high rates needed to pay depositors and still earn a profit for the bank owners.

So the most bullish financiers paying, let’s say, 5 percent interest to depositors might find it difficult to find enough ways to invest the funds to earn, say, an average profit of 8 percent, leaving enough profit margin to pay the bank’s expenses and still provide dividends to the bank owners. Banks paying high rates to attract depositors may seek more and more risky investments in order to cover their cost of funds. If the economy is booming, such bullish financiers may grow fast and profit well, but if growth falters and high-yield investments become scarce or start to fail, the most bullish financiers can be squeezed between the rising cost of their funds and the falling value of their investments.

The case reviewed in the Wall Street Journal article is like that. It says, “Droves of investors from around China have descended on Shanghai Kuailu Investment Group’s swanky offices over the past week to demand their money back after the firm halted redemptions on wealth-management products for the roughly 250,000 clients of the firm and three affiliates.” The details show that this is a specific case of the general problems bullish finance faces when economies slow.

Some background: wealth management products are like savings accounts for people who want higher returns than they can get in the regulated state-owned banks. Depositors are often not fully aware of the potential risks of investing their wealth in less regulated “shadow banks” like Kuailu. The question on everyone’s mind now is whether the Chinese government will act to either reign in or bail out such dangerously overexposed bulls.

This always presents a dilemma. Bailing them out creates what economists call a “moral hazard” problem. In other words, other firms may become even more eager to pay higher deposit rate and make riskier and riskier investments expecting that if they fail the government will socialize their losses, bailing them out with taxpayer funds. I believe the Chinese government is very likely to stand behind its own banks, but much less certain to bail out privately-owned and bullishly operated shadow banks. An even bigger problem might be the overexposure to failing RMB loans by the huge Hong Kong private banks, which are also unlikely to be bailed out by the Chinese government, at least not without a very steep political price.

On the other hand, not bailing out large financial institutions may create a risk to China’s entire financial system. Investors’ moods may swing from optimism to panic overnight. Lack of transparency does not help. Not knowing which financial institutions may be in trouble, panicky depositors may line up to pull funds out of those that are still solvent as well as the more troubled ones. The net effect of such a system-wide panic is a vicious circle of credit contraction as bulls retreat and bears show their teeth. More on that next week as I return to the concept of capitalism in general. 

*****

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of David Shankbone]

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