By Alfred Duncan*
Banks borrow through on-demand deposits and lend these funds long term.
This ‘maturity mismatch’ is an imbalance of timing that they have to manage and which exposes them to risk.
However, the mismatch is valuable to customers who wish to hold on-demand assets but borrow for longer durations, and the vertical integration between deposit and lending products helps banks build relationships which are important for managing and assessing loan risk.
Bank deposits also facilitate trade by providing liquidity: banks offer safe, secure and fast payment services for households and firms. For large transactions in particular, bank payments such as cheques are much more convenient for households and firms than cash transactions.
The flow must go on
The value of banks to the economy is most obvious when the relationships break down.
Bank failures are more widely felt than failures of other firms because of the trade linkages that banks provide: they stop trade in its tracks, severely deplete private net worth, and restrict households’ and firms’ access to credit and investment products.
The propagation of the effects of bank failures through the economy means that when a bank collapses, the social costs felt by firms and households can be greater than the private costs incurred by the failed bank’s shareholders and creditors.
While these social costs can be dampened by government guarantees of bank deposits and by the central bank’s provision of liquidity in crises, both actions reduce the private costs of failure and the incentives for bankers to mitigate risk.
In practice, the social costs of bank failure are so high that governments and central banks cannot credibly commit to not supporting vulnerable or even insolvent banks in a crisis. Whether or not there are explicit government supports in place, the expectation of support in a crisis has an effect on the risk-taking behaviour of bank creditors, shareholders and managers.
All firms fund themselves through a mixture of debt and equity. The optimal debt share of funding (or leverage) is influenced by features of the organisational structure and taxation.
For most firms, an increase in leverage beyond some level would lead to an increase in the interest rates charged by the firm’s lenders.
For banks with deposit guarantees (even if implicit), an increase in leverage may not increase the insolvency risk to depositors; rather, it may increase the risks to the taxpayer (and the potential payoffs to shareholders in good times).
With depositors not demanding a premium for risk, banks have an incentive to pursue risks and leverage ratios that are greater than what would be socially efficient.
Similarly, most firms would be wary of maturity mismatch between assets and liabilities. Any rise in interest rates would quickly raise their cost of capital and could force them to liquidate assets at large discounts.
For banks with central-bank credit lines, the risk of a spike in short-term interest rates is dampened as they have access to the central bank’s funds if the market for their deposits tightens up.
Do guarantees regulate flows … or raise risks?
To the extent that government guarantees and central-bank credit lines reduce the cost of funding for banks, they subsidise leverage and liquidity mismatch, which increases the likelihood of future banking crises.
Hence regulation of banks’ leverage and maturity mismatch is often imposed with the aim of preventing bank failures.
Market discipline is dampened but not eliminated by government supports.
Figure 1 shows two key measures of how the credit risk of New Zealand banks was perceived during the recent subprime financial crisis. Each measure is a credit spread, measuring default risk by taking the difference between the cost of 90-day bank bond borrowing rates and 90-day government bond (NZ Government bills) borrowing rates.
The black line shows the spread associated with offshore borrowing by NZ banks (90-day NZD LIBOR). The orange line shows the spread associated with domestic borrowing by NZ banks (90-day NZD bank bills).
Normally, these measures would be so closely linked that the spread would be negligible: an increase in the borrowing cost in one market would encourage banks to raise funds in the other. However, this link can be disrupted in times of financial stress.
The bankruptcy filing of US-headquartered investment bank Lehman Brothers on 15 September 2008 had dramatic consequences for financial markets. Funds in Lehman Brothers’ brokerage accounts (considered by clients to be safe) were instantly frozen and remain so to this date as the financial behemoth and its subsidiaries work through bankruptcy and administration proceedings in a number of countries.
A dramatic rethink of the safety of financial firms that had been previously considered sound was translated into large withdrawals from bank deposit accounts, investment bank brokerage accounts, and money market funds in major financial centres. This is reflected in the significant volatile spreads following the Lehman Brothers failure.
New Zealand banks were not shielded from the panic, and the interest rates demanded by foreign depositors in particular jumped to around three percentage points above pre-crisis levels. If sustained, such increases in funding costs force banks to stop lending to households and firms and can lead to recessions.
Balancing regulation, risk and value
While leverage and liquidity mismatch are key contributors to bank risk, they are also drivers of banks’ value.
Leverage and liquidity mismatch are essential for the deposit account products that banks provide to customers.
On-demand deposits are useful because they can be readily withdrawn or used for payments, and deposit account activity gives banks information about customers that can be used to better judge their ability to repay loans. The information gathered from deposit accounts makes banks efficient channels of capital allocation, particularly towards entrepreneurs, small businesses and households.
Liquidity mismatch may also impose greater discipline on managers: when debt is on-demand along with deposits, a small proportion of depositors withdrawing their funds can cause a run and force the bank into liquidation.2 Fewer monitoring debtholders are required to impose discipline on managers.
As most bank depositors are uninformed about their bank’s financial health, this disciplining role of on-demand debt may be important for reducing risks taken by bank shareholders and managers.
Implicit or explicit government support may encourage excessive leverage and liquidity mismatch, but regulators need to keep in mind the importance of leverage and on-demand deposits for relationship lending and creditor monitoring of bank managers.
Moreover, any de jure limits may not even be de facto enforceable in many cases.
Banks are peculiar in the sense that each bank’s individual value is due largely to its information advantages over its rivals.
Banks seldom own many tangible assets, and their products are unable to be patented or protected from replication by their peers. In order to make profits in a competitive environment, individual banks must have greater knowledge of the risks and rewards of their products than their rivals do, and they must promote this view with a reputation for soundness and service.
A bank that can more accurately gauge the risk of lending to borrowers in a particular market will be able to earn greater profits in that market over the long term than a bank with less information or less-accurate models. Regulations that are dependent on knowledge of the characteristics of a bank’s assets may be unenforceable if the bank is able to pull the wool over the eyes of the regulator; not unforeseeable when their profits depend on them keeping this informa-tion from their competitors.
Such a package of regulations also needs to be constantly altered and manipulated.
The risks associated with lending or borrowing in a given market will depend on the business cycle, terms of trade, and other market-specific developments.
In isolation, limits on leverage and liquidity metrics may reduce banks’ vulnerabilities to economic shocks. However, regulatory packages that internalise a greater share of the risks of banking may be more effective at reducing the vulnerability of the financial system. Regulations should compel bank managers and shareholders to reduce risk by aligning their incentives with those of the public.
Regulations which simply place caps on observable risk metrics will be less effective, and may reduce the efficiency of the sector.
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In the next issue of Competition & Regulation Times, Alfred Duncan will examine some particular features of the New Zealand banking regulatory framework.
1 This project was suggested by Professor Lewis Evans, who also provided comments on earlier drafts.
2 CW Calomiris & CM Kahn (1991) ‘The Role of Demandable Debt in Structuring Optimal Banking Arrangements’ American Economic Review 81(3) pp497-513.
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Alfred Duncan is a PhD student in financial economics at the University of Glasgow and a former research assistant at ISCR.
This article was first published by the ISCR in the July 2012 issue of their "Competition and Regulation Times". It is republished here with permission.
The ISCR website is here » and a .pdf version of their Issue #38 is here »
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