Felix Salmon

Why bank deposits shouldn’t be an asset class

By Felix Salmon
January 5, 2012

Amar Bhidé has responded to my piece about his proposal to guarantee all bank deposits.

First, he says that the real stupidity in Ireland wasn’t the blanket guarantee of bank deposits; after all, he says, “virtually all Western governments implicitly or explicitly guaranteed all bank deposits (and other forms of short term cash, such as money market funds) in 2008″. Instead, it was Ireland’s guarantee of bank bonds. “this was dumb”, says Bhidé, “but it has nothing to do with whether or not deposits should be guaranteed”.

I think the two are in fact intimately connnected. Deposits are a funding source for banks, as are bonds. If you take in more of the former, you’ll issue less of the latter; cheap deposits will quickly chase out expensive bonds. If investors start flocking into 1-year and 3-year certificates of deposit on the grounds that they’re federally guaranteed, it’s hard to see how investors would find 5-year or 10-year uninsured bonds particularly attractive, unless they yielded a lot more than the CDs. And it’s equally hard to see why the bank would feel the need to pay through the nose to issue expensive 10-year debt, when it had unlimited access to much cheaper short-term funding instead.

Bhidé says that capital requirements would force banks to issue bonds — but I don’t see it. If there’s one thing we learned during the financial crisis, it’s that no one really considers subordinated debt to be useful capital: no bank has ever defaulted on its bonds and survived. In other words the kind of capital you get by issuing bonds is the kind of capital no one particularly wants. Instead, investors and regulators are increasingly looking at pure equity, in the form of metrics like TCE. I would hope that we’ve moved away from the paradigm that when a bank wants to improve its capital ratios, it issues a bunch of new liabilities which mean certain death if they’re ever defaulted on. That doesn’t strengthen a bank at all, and everybody knows it.

Bhidé’s proposal wouldn’t just destroy price discovery in the bank-debt market. It would also have the effect of raising interest rates more broadly, and increase the US government’s cost of borrowing. After all, bank CDs are always going to yield more than Treasury notes. If they carry exactly the same government guarantee, then there will be a significant move out of Treasuries and into bank deposits. I can’t see why the government would want that.

And yes, a lot of governments did implicitly or explicitly guarantee all bank deposits during the crisis. But here’s the thing: implicit guarantees are better than explicit guarantees, and temporary guarantees are better than permanent guarantees. Bhidé wants a permanent explicit guarantee, which is the worst of all.

An explicit and permanent guarantee on bank deposits would, overnight, create a whole new risk-free asset class — in a world where we’ve learned time and time again that risk-free asset classes are a Really Bad Thing. Investors tend to put inordinate value on safety, when what we really want to encourage is risk-taking. And highly-regulated banks with massive government-guaranteed bank deposits are not the best mechanism for allocating risk capital. Markets might not be perfect, but they’re surely better at capital allocation than that.

As companies like Apple build up their cash reserves into the tens of billions of dollars, we’re already beginning to see a world where bank deposits are becoming something of an asset class. It’s not a world we should encourage — let alone one we should institutionalize with a blanket government guarantee. Money should be invested; the government has no business encouraging corporations and institutional investors to simply park it in a bank instead.

13 comments so far | RSS Comments RSS

So if all bank deposits are guaranteed by the government, then what’s to stop banks from investing those deposits in the highest yielding but riskiest investments? Don’t say capital requirements, because the banks don’t even like 10:1 ratios.

Having the government guarantee all bank deposits will buy us nothing but an inevitable bailout for banks. There is already plenty of cash sitting around doing nothing (and earning nothing), so this would just be a handout to companies that don’t need it. It solves nothing.

Posted by KenG_CA | Report as abusive

I had been meaning to comment on the previous post and decided against, but now that you are back on this, I think you are way off mark here. I think the critical point is not the current deposit infrastructure, but rather the fact that an entirely parallel deposit infrastructure (i.e., shadow banking) has been developed to cope with the uninsured deposits.

In this vein, the work of both Gary Gorton and Sam Pozsar is very instructive. The first one has shown at length how the 2008 crisis was nothing more than a run on the repo market functionally identical to the banking panics pre-1913 and pre-FDIC. The second one has shown, pretty convincingly, that a huge driver behind the emergence of the repo market was the rise of institutional cash pools, which, exceeding insurance limits, had to find a way to deposit their cash without taking on significant risk (by becoming junior unsecured creditors in any amount over $100,000 – now $250,000). I’d say it’s a great bet that apple and google don’t want to run repo desks, but if the alternative is to take on single-A credit risk, they’ll do that all day long.

Speaking exclusively about deposits, without acknowledging how wholesale deposits have moved into the shadow banking system is, at best, incomplete.

Posted by intrstdobsrvr | Report as abusive

“we’ve learned time and time again that risk-free asset classes are a Really Bad Thing”

Oh really. I thought you said there was no such thing as a risk-free asset class. You can’t have it both ways – how can we learn “time and time again” from something that doesn’t exist?

“Money should be invested; the government has no business encouraging corporations and institutional investors to simply park it in a bank instead.”

OK, suppose that there exists a risk-free account and it pays 0% interest. People who choose to deposit in this account have decided that they see no investment opportunities that pay more. Why does the government have any business contradicting them? Why is some apparatchik (Freedom’s Fighter Comrade Felix?) supposed to be smarter than the market?

The first part of your premise is fine: there is no need for the government to guarantee deposits or any other investment vehicle provided by private enterprise. But to achieve this we have to forget the rest of your rant: the government should allow every citizen and every commercial entity to hold deposits at the central bank. Such deposits are risk-free and accordingly pay the lowest possible interest rate, a rate determined by the CB in order to achieve the policy objectives mandated to it by the government. Want more interest? You’ll have to accept the risk.

It is the *lack* of this facility that currently creates so many market distortions, such as the use of repo for risk-free deposits and precious metals as savings vehicles.

If you don’t know what I’m talking about, read Ashwin here: http://www.macroresilience.com/2012/01/0 5/the-public-deposit-option-an-alternati ve-to-regulate-and-insure-banking/.

Posted by Greycap | Report as abusive

Interestingly neither solves problems that we experience, however this represents the essence of the free market economy

Posted by JackOno | Report as abusive

“Bhidé wants a permanent explicit guarantee, which is the worst of all”

I like the concept of drawing these distinctions, but I believe that a permanent implicit guarantee is worst of all. That’s the classic formula for privatizing profit and socializing loss, and it’s exactly why that occurred at Fannie Mae and Freddie Mac. It’s clearly worse than a permanent explicit guarantee. Fees can be charged for an explicit guarantee, as is done for FDIC deposit insurance, so it’s possible for the program to be self-funding. That obviously can’t work for an implicit guarantee – how can one charge for a guarantee that doesn’t exist? An explicit guarantee is also much cleaner from a regulatory standpoint. With implicit guarantees, pushback against regulation can include the notion that the guarantee doesn’t exist.

Posted by realist50 | Report as abusive

There is a fundamental difference between deposits and bond financing for banks. Deposits can be withdrawn on demand. Bonds eventually roll over, but in a predictable and generally manageable fashion.

Had Ireland insured all of the deposits and none of the existing bonds, it might still have had to insure new/rollover bond issuance, but that would still have been much less expensive as it would have allowed the insolvency of the banks to become evident in a timely manner. As it was, the guaranteed bonds were mostly rolled over by the time the guarantee expired.

Posted by danjryan | Report as abusive

I don’t think you want to be living in this country when ordinary people discover that their banks have failed without insurance. That’s why there is FDIC insurance. Whether an to what extent it should be limited is a matter of degree. Even 250,000 is probably inadequate. They also won’t let money markets fail. The government would collapse.

Posted by maynardGkeynes | Report as abusive

Felix… “Money should be invested; the government has no business encouraging corporations and institutional investors to simply park it in a bank instead.”

Money parked in a bank is invested… by the bank. My bank invests 55% of our 1 billion dollars in assets in loans to people, 35% in loans to businesses, 5% in marketable securities, and 5% in other stuff like bank owned life insurance or the physical bank branches that we own rather than lease.

The only money not “invested” by my bank would be the physical vault cash that we have to carry to transact business; that’s only a couple million total for a billion dollar bank. Since we have about a 12% capital cushion our total outstanding loans exceed our total deposits.

I totally agree with you that FDIC insurance should be limited. What the right limit is could be debated. That one person should be able to park money at a dozen or many dozen banks to insure many millions of dollars could be debated. I will say thougth that I personally work with many elderly customers who want only to earn the highest possible federally insured rate or return. I spoke to an 80 year old man this week who very elequently explained why he would rather make 1% with a zero % chance of loss than make 10% with a one in a million chance of loss.

Posted by y2kurtus | Report as abusive

One characteristic of Irelands Banks that may not be immediately apparent is that huge proportions of their business is conducted in the UK, where many if not most of their customers live. The expatriate Irish in the UK and their businesses and descendants favour Irish banks over British ones.

When the crisis hit, the politicians of the day panicked and saw a run on Ireland’s banks causing a big problem with UK residents calling the shots. The politician in charge was asked in the street what he was going to do and said an unwise, off the cuff remark about the Irish banks being 100% safe, and didn’t want to lose face afterwards when his advisors tried to correct him, so he made it government policy. It seems he also muddled the asset classes too.

Posted by FifthDecade | Report as abusive

One of the cleverest tricks banks have pulled is convincing most people of simultaneous truth of these three logically inconsistent theories:

1. The government should create sufficient risk-free assets to satisfy people’s desire to hold cash substitutes. These assets should never faces losses in any scenario and should be completely fungible. At the same time, they should be organized in a complex manner that makes it difficult for people to trade them outside the banking system, so that bankers can collect fees on trading them.

2. Those same risk-free assets should also be funding for banks’ risky activities. Interest rates should be manipulated by the government in order to bail out unsuccessful risky activities. When a bank fails, the government should step in and make depositors whole.

3. Banks operate in a free market and any government intervention in their risk-taking is socialism that will lead to inefficiency…or worse!

You could believe various parts of this story, but the whole thing together is delusional. If the government is going to be this heavily involved, the government could directly issue all risk-free assets and then fund banks according to their safety and soundness and opportunities for lending. In fact, this is what our system already amounts to, except that it explicitly allows more looting (the Fed/FDIC won’t really step in until you’ve gathered a lot of deposits with above-market interest rates and then blown them on risky investments).

Posted by najdorf | Report as abusive

If you want to put lots of money in a form guaranteed by the government, buy T-bills.

Posted by dWj | Report as abusive

- ALL deposits at the big TBTF crony banks are essentially insured without limit.
- The question is only whether you want to enable smaller banks to be able to compete on equal footing for large deposits, or you want TBTF banks to enjoy another undeserved advantage.
- By “investing” your money, your money does not get safer. As the practice on Wall St is to hold your investments in “street name” you dont really own your stocks but only have a claim against your broker.

Posted by vlscout | Report as abusive

If it’s been said, it’s important to repeat: banks must make sufficient performing loans and from the interest and principal payments serving as a revenue stream, these become real operating cash flows so that banks do NOT have to do things like parasite on their depositors’ money or borrow in commercial paper or repo/borrowings markets or Fed funds purchased relying – on all of these for liquidity.

In the US the Fed examines banks, especially smaller banks and disciplines them if they have insufficient operating cash flows from performing loans and other typical commercial banking and cash financial instrument trading for fee revenue that realizes to cash in the reporting cycle. Accrual basis accounting is key and for revenues to realize to cash in the reporting cycle too is key.

There is a double standard however, the Fed exercises applying more safety and soundness discipline for the non ISDA (smaller) BHCs while for the ISDA cartel the Fed is complicit and facile to those bigFinancials’ interests and operating strategies of inflating their balance sheet with abusive contracting of OTC derivative contracts that when Fair Vauled in an upward or level market, the unrealized non cash gains from the FV is run thru the income statement to game it, manage earnings. The corruption of the unrealized non cash gains is a form of a fraud – it gives appearance of a revenue stream rising to the quality of revenues from performing loans or cash financial instrument trading, but not in that the fair valuing fails to produce revenues that realize to cash in the reporting cycle.

In a shrinking economy with less, fewer opportunities to make performing loans, without their abusive and agency self-dealing of proliforating OTC derivatives contracts, ISDA banks would not be profitable and would have to sell operating units and/or sell assets in order to summon liquidity. In a correcting market, this gives us difficulty to sell assets the prices of which the sellers expect to hold up while the market is correcting and other bigFinancials similarly are looking to sell assets or operating units.

The regulators which may be guilty aren’t that stupid and want it easier to separate what can be sold when a bigFinancial has to execute its ‘living will’.

Moreover, relying on borrowings and the fair valuing of the balance sheet inflated with OTC derivatives contracting, leaves the bank again at risk for having to execute its living will if and when the Fed stops QE and other liquidity programs that especially the ISDA cartel have needed in order to remain operating and appear profitable.

Managements relying on its depositors money gives us the risk of MF Global. Dirty secret is however that in that industry it wasn’t illegal for MF Global to use its customers’ money.

Regulators which find banks relying on using its depositors’ money puts that bank or thrift of BHC, or FHC under an MOU and if the reasons aren’t solved that management hasnt sufficient operating cash flows from its banking activities, the organ then goes under a cease & desist, and some one in senior management has to leave the company. Sadly in 2007-2010 we didnt see this with the ISDA banks, however there is precident for regulators to resume normal behavior.

Perhaps in the UK and EU a depository financial institution can ‘borrow’ its customers’ deposits, but that then is sick depository institution and its management is a hair away from being reprimanded or if caught in a market correction or another crisis, out of their jobs.

Posted by andreapsoras | Report as abusive

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