April 27, 2023
“Your money’s not here… Your money is in Joe’s house, right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others… and they’re gonna pay you back as best they can…”
– George Bailey, It’s a Wonderful Life
It was a simple lesson that old George explained to his depositors trying to hold off a run on the Bailey Building and Loan during what would become the Great Depression.
He wasn’t lying…
At its most basic level, a bank’s business involves two things: taking deposits and making loans.
Banks accept deposits from their customers which they record on their balance sheets as liabilities. They then turn around and lend the the deposited money out in the form of loans — and record them as assets. (Counting the same capital as an asset and liability is magic you can only find in the banking industry.)
They pay one rate of interest to their depositors, and receive a higher rate of interest from those they lend to.
The difference between the rates is the bank’s profit.
Sounds simple enough. But it’s really only half the story…
The Asset-Liability Mismatch
The banking business operates on something known as an Asset/Liability Mismatch.
It’s also known as “borrowing short and lending long.”
For the most part, the deposits (liabilities) they take in — the money banks “borrow” — are short term loans to the bank. You might have heard the term “demand deposit.” That means you can go to your bank and “demand” your money anytime you want it.
Because they are theoretically short term commitments of money, they get paid a low rate of interest.
The loans banks make, on the other hand, are typically for much longer terms: car loans, mortgages, etc. Because they commit their capital for so much longer, they get paid more.
But…
They no longer have access to that money for the term of the loan. (They can sell the loan, but how much they get paid for it will depend on the rate the loan is paying versus what the market is paying when they try to sell it.)
This creates a pretty unusual cash flow situation if you think about it. A bank may record a billion dollars in deposits, but like George explained, they never have anything close to a billion dollars on hand.
During normal times, it’s not a problem because people generally aren’t worried about their money in the bank.
These aren’t normal times.
What’s a Bank to Do?
The recent collapse of SVB and Signature Banks put this vulnerability in the spotlight.
When a large group of depositors wanted to take their money out of the bank, their demands couldn’t be met (because they loaned that money out). Trying to sell the bonds (loans they made to the government) they held to raise capital resulted in massive losses on those assets.
A large chunk of the smaller regional bank market is currently being watched for any signs of trouble.
So what does a bank do when they’re faced with this situation?
They stop (or greatly reduce) lending. This results in what’s known as a credit crunch.
The chart below is from the Federal Reserve Bank of Chicago. It shows their National Financial Conditions Index.
Chicago Fed National Financial Conditions Credit Subindex
When the index rises above zero, financial conditions are getting tighter. Tighter financial conditions mean banks are generally lending less.
When banks stop lending, economies slow down.
This indicator will definitely be one to watch!
Make the trend your friend,
Bob Byrne
Editor, Streetlight Daily