In a nerve-wracking sequence, a succession of American banks failed this year.
Unlike in the 2007-08 Global Financial Crisis, the recent failures mostly began on the liabilities side of the banks’ balance sheets, rather than on the asset side.
For banks, deposits are liabilities; and the successive failures played out like old-fashioned runs on deposits.
The failures sparked desperate action among central banks, financial regulators and national and state governments. They also nourished a vibrant tertiary market in the entrails of the failed banks.
(The primary market in listed companies is the Initial Public Offerings market, which is where companies’ shares are first issued. The secondary market is the trade in existing shares. What we call the ‘tertiary market’ is the much more exclusive wheeling and dealing that happens after banks fail, or after governments, central banks and regulators step in to manage the failure process.)
To understand the tertiary market, it is useful to do some quick ‘Bank liquidation 101’.
What, essentially, is a bank? It is a workforce and a brand and a set of systems and accounts. But essentially, at bottom, it is a bundle of assets and liabilities, activated and mobilised by a government-issued licence to operate.
Loans constitute the bulk of banks’ assets, while deposits are their principal liabilities.
Contrary to popular belief, banks’ loans and deposits are not intermingled. Banks are almost universally thought of as intermediating between depositors and lenders, but that view is a mistake. Banks do not collect deposits to ‘lend them out’.
(Nor do they lend out their ‘reserves’. Today, ‘reserves’ are a special category of balances with central banks, and they serve as inter-bank transfer tokens.)
In fact, banks don’t particularly relish holding deposits at all. For banks in ordinary times, deposits can be a costly nuisance; and in times of financial turmoil and general nervousness, deposits can be a source of potentially fatal risks.
(One exception: a bank running short of inter-bank transfer tokens may seek deposit flows from other banks, not because of the deposits themselves, but because the inter-bank flows bring tokens with them.)
For bank liquidators, splitting up a failed bank is surprisingly straightforward. Because banks don’t intermediate between loans and deposits, the bank’s assets and liabilities are largely in discrete boxes, and the assets of a failed bank are surprisingly valuable — hence the vibrant tertiary market. (Contrary to another popular belief, there is no vibrant tertiary market for deposits.)
After the recent bank failures, a small number of large and well placed banks were able to pick up the assets of failed or failing banks on extremely favourable terms.
J.P. Morgan bought most of California-based First Republic in a sweet deal, for example, while in Europe UBS bought Credit Suisse, and a UK subsidiary of HSBC acquired Silicon Valley Bank UK — for £1.
Through this process, we saw an unprecedented flow of deposits and capital towards the largest private banks.
Shareholders in the failed and failing banks were right to be cheesed off. Shareholders in other smaller and mid-sized banks around the world were right to be nervous.
The big banks drew criticism for paying pennies in the dollar for valuable assets that warranted no such discount.
The resulting gains for the large banks were big, but they were not net gains at the system level. There are no free lunches in bank failures.
The benefits were at the expense of the original shareholders and bondholders, of course. But they were also at the expense of the remaining smaller and medium-sized banks, all of which subsequently faced a higher cost of capital.
Another group to lose out: the smaller communities and customers who do not appear on the megabanks’ radars. J.P. Morgan is hardly concerned with start-ups and small businesses in Milwaukee or Fresno or Salt Lake City.
Beyond the immediate impacts on depositors and shareholders and staff, the main longer-term danger from a domino chain of bank failures and the flow of loans and deposits to the mega-banks is that whole communities and entire categories of businesses will be unserved or under-served.
To the extent that commercial banks perform a useful function in capitalism, that function will be significantly curtailed. The result will be less investment, tighter lending conditions and more moribund regional economies.
That means, when Wall Street sharks eat up minnows and middle-sized fish, we all lose.
The rolling sequence of bank failures felt like a slow-motion disaster, but the crisis was not all bad news.
Because they came mostly from the deposit side of bank balance sheets, the failures were eminently preventable. Governments, financial regulators and central banks had no reason to feel powerless or despondent.
In 2023, a bank that suffers a deposit run will experience financial distress when it runs out of inter-bank transfer tokens, a.k.a. ‘reserves’.
But it is wholly within the power of the Federal Reserve to lend those tokens to banks in distress. It would also be possible for governments and central banks to create a special category of emergency tokens that can be gifted to banks in distress, to make sure a run on deposits cannot spiral into a collapse.
Let’s be entirely clear. The recent US bank failures happened because the Fed and other oversight institutions were ill-prepared and did not act quickly enough. Now, they have every reason to be prepared, and they know what tools they need.
If another mid-sized bank fails due to a run on deposits, its shareholders have every right to be very unhappy indeed. And the community as a whole has every right to ask why the nominal protectors and overseers of our financial system have been asleep at the wheel.
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