17.1 Banking: Benefits and Dangers

As we learned in earlier chapters, banks perform an essential role in any modern economy. In Chapter 14 we defined commercial banks as financial intermediaries that provide liquid financial assets in the form of deposits to savers and uses its funds to finance the illiquid investment spending needs of borrowers. Deposit-taking banks perform the important functions of providing liquidity to savers and directly influencing the level of the money supply.

Lehman Brothers, however, was not a deposit-taking bank. Instead, it was an investment bank (also defined in Chapter 14)—in the business of speculative trading for its own profit and the profit of its investors. Yet Lehman got into trouble in much the same way that a deposit-taking bank does: it experienced a loss of confidence and something very much like a bank run—a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure. Lehman was part of a larger category of institutions called shadow banks. Shadow banking, a term coined by the economist Paul McCulley of the giant bond fund Pimco, is composed of a wide variety of types of financial firms: investment banks like Lehman, hedge funds like Long-Term Capital Management (LTCM), and money market funds. (As we will explain in more detail later, “shadow” refers to the fact that before the 2008 crisis these financial institutions were neither closely watched nor effectively regulated.) Like deposit-taking banks, shadow banks are vulnerable to bank runs because they perform the same economic task: asset or maturity transformation, the transformation of short-term liabilities into long-term assets. From now on, we will use the term depository banks for banks that accept deposits (so commercial “banks” include chartered banks, trust, mortgage and loan companies, credit unions, and caisses populaires) to better distinguish them from shadow banks (investment banks, hedge funds, and money market funds) which do not.

The Trade-off Between Rate of Return and Liquidity

Imagine that you live in a world without any banks. Further imagine that you have saved a substantial sum of money that you don’t plan on spending anytime soon. What can you do with those funds?

One answer is that you could simply store the money—say, put it under your bed or in a safe. The money would always be there if you need it, but it would just sit there, not earning any interest.

Alternatively, you could lend the money out, say, to a growing business. This would have the great advantage of putting your money to work, both for you, since the loan would pay interest, and for the economy, since your funds would help pay for investment spending. There would, however, be a potential disadvantage: if you needed the money before the loan was paid off, you might not be able to recover it.

It’s true that we asked you to assume that you had no plans for spending the money soon. But it’s often impossible to predict when you will want or need to make cash outlays; for example, your car could break down or you could be offered an exciting opportunity to study abroad. Now, a loan is an asset, and there are ways to convert assets into cash. For example, you can try to sell the loan to someone else. But this can be difficult, especially if you need cash on short notice. So, in a world without banks, it’s better to have some cash on hand when an unexpected financial need arises.

In other words, without banks, savers face a trade-off when deciding how much of their funds to lend out and how much to keep on hand in cash: a trade-off between liquidity, the ability to turn one’s assets into cash on short notice, and the rate of return, in the form of interest or other payments received for the use of one’s assets. Without banks, people would make this trade-off by keeping a large fraction of their wealth idle, sitting in safes rather than helping pay for productive investment spending. Banking, however, changes that by allowing people ready access to their funds even while those funds are being used to make loans for productive purposes.

The Purpose of Banking

Banking, as we know it, emerged from a surprising place: it was originally a sideline business for medieval goldsmiths. By the nature of their business, goldsmiths needed vaults in which to store their gold. Over time, they realized that they could offer safekeeping services for their customers, too, because a wealthy person might prefer to leave his stash of gold and silver with a goldsmith rather than keep it at home, where thieves might snatch it.

Someone who deposited gold and silver with a goldsmith received a receipt that could be redeemed for those precious metals at any time. And a funny thing happened: people began paying for their purchases not by cashing in their receipts for gold and then paying with the gold, but simply by handing over their precious metal receipts to the seller. Thus, an early form of paper money was born.

Meanwhile, goldsmiths realized something else: even though they were obligated to return a customer’s precious metals on demand, they didn’t actually need to keep all of the treasure on their premises. After all, it was unlikely that all of their customers would want to lay hands on their gold and silver on the same day, especially if customers were using receipts as a means of payment. So a goldsmith could safely put some of his customers’ wealth to work by lending it out to other businesses, keeping only enough on hand to pay off the few customers likely to demand their precious metals on short notice—plus some additional reserves in case of exceptional demand.

And so banking was born. In a more abstract form, depository banks today do the same thing those enterprising goldsmiths learned to do: they accept the savings of individuals, promising to return them on demand, but put most of those funds to work by taking advantage of the fact that not everyone will want access to those funds at the same time. A typical bank account lets you withdraw as much of your funds as you want, anytime you want1—but the bank doesn’t actually keep everyone’s cash in its safe or even in a form that can be turned quickly into cash. Instead, the bank lends out most of the funds placed in its care, keeping limited reserves to meet day-to-day withdrawals. And because deposits can be put to use, banks don’t charge you (or charge very little) for the privilege of keeping your savings safe. Depending on the type of account you have, they might even pay you interest on your deposits.

Maturity transformation is the conversion of short-term liabilities into long-term assets.

More generally, what depository banks do is borrow on a short-term basis from depositors (who can demand to be repaid at any time) and lend on a long-term basis to others (who cannot be forced to repay until the end date of their loan). This is what economists call maturity transformation: converting short-term liabilities (deposits in this case) into long-term assets (bank loans that earn interest). Shadow banks, such as Lehman Brothers, also engage in maturity transformation, but they do it in a way that doesn’t involve taking deposits.

A shadow bank is a non-depository financial institution that engages in maturity transformation.

Instead of taking deposits, Lehman borrowed funds in the short-term credit markets and then invested those funds in longer-term speculative projects. Indeed, a shadow bank is any financial institution that does not accept deposits but does engage in maturity transformation—borrowing over the short term and lending or investing over the longer term. And just as bank depositors benefit from the liquidity and higher return that banking provides compared to sitting on their money, lenders to shadow banks like Lehman benefit from liquidity (their loans must be repaid quickly, often overnight) and higher return compared to other ways of investing their funds.

A generation ago, depository banks accounted for most banking. After about 1980, however, there was a steady rise in shadow banking, especially in the United States. Shadow banking has grown so popular because it has not been subject to the regulations, such as capital requirements and reserve requirements, that are imposed on depository banking. Shadow banks, facing less regulatory oversight, can offer their customers a higher rate of return on their funds; in that way, they are similar to the unregulated trusts at the start of the twentieth century, which set off the U.S. Panic of 1907. These trusts had attracted large pools of deposits by offering high interest rates. The deposits were channelled into real estate investments during a speculative bubble. When the bubble burst, many trusts failed, which led to a crisis of confidence; this in turn, caused a severe banking crisis and recession. As of July 2007, generally considered the start of the financial crisis that climaxed when Lehman fell in September 2008, the U.S. shadow banking sector was about 1.5 times larger, in terms of dollars, than the formal, deposit-taking banking sector.

As we pointed out in Chapter 14, things are not always simple in banking. There we learned why depository banks can be subject to bank runs. As the cases of Lehman and LTCM so spectacularly illustrate, the same vulnerability afflicts shadow banks. Next we explore why.

Shadow Banks and the Re-emergence of Bank Runs

Because a depository bank keeps on hand just a small fraction of its depositors’ funds, a bank run typically results in a bank failure: the bank is unable to meet depositors’ demands for their money and closes its doors. Ominously, bank runs can be self-fulfilling prophecies: although a bank may be in fine financial shape, if enough depositors believe it is in trouble and try to withdraw their money, their beliefs end up dooming the bank.

To prevent such occurrences, after the 1930s Canada (and most other countries, including the United States) adopted wide-ranging banking regulations in the form of regular audits by the central bank, capital requirements and reserve requirements, deposit insurance, and provisions allowing troubled banks to borrow from the central bank in the overnight market.

Shadow banks, though, don’t take deposits. So how can they be vulnerable to a bank run? The reason is that a shadow bank, like a depository bank, engages in maturity transformation: it borrows short term and lends or invests longer term. If a shadow bank’s lenders suddenly decide one day that it’s no longer safe to lend it money, the shadow bank can no longer fund its operations. Unless it can sell its assets immediately to raise cash, it will quickly fail. This is exactly what happened to Lehman.

Lehman borrowed funds in the overnight credit market (also known as the repo market), funds that it was required to repay the next business day, in order to fund its trading operations. So Lehman was on a very short leash: every day it had to be able to convince its creditors that it was a safe place to park their funds. And one day, that ability was no longer there. The same phenomenon happened at LTCM: the hedge fund was enormously leveraged (that is, it had borrowed huge amounts of money)—also, like Lehman, to fund its trading operations. One day its credit simply dried up, in its case because creditors perceived that it had lost huge amounts of money during the Asian and Russian financial crises of 1997–1998.

Bank runs are destructive to everyone associated with a bank: its shareholders, its creditors, its depositors and loan customers, and its employees. But a bank run that spreads like a contagion is extraordinarily destructive, causing depositors at other banks to also lose faith, leading to a cascading sequence of bank failures and a banking crisis. This is what happened in the United States during the early 1930s as Americans in general rushed out of bank deposits—the total value of bank deposits fell by 35%—and started holding currency instead. Until 2008, it had never happened again in the United States. Our next topic is to explore how and why bank runs reappeared.

THE DAY THE LIGHTS WENT OUT AT LEHMAN

On Friday night, September 12, 2008, an urgent meeting was held in the New York Federal Reserve Bank’s headquarters on Wall Street. Attending was the outgoing Bush Administration’s Treasury Secretary, Hank Paulson, and Tim Geithner (at that time head of the New York Fed and later the Treasury Secretary in the Obama Administration), along with the heads of the country’s largest investment banks. Lehman Brothers was rapidly imploding and Paulson called the meeting in the hope of pressing the investment bankers into a deal that would, like the LTCM bailout described in Chapter 14, avert a messy bankruptcy.

Richard Fuld, the head of Lehman, testified before a congressional panel on how the collapse of Lehman precipitated a financial panic.

Since the forced sale of the nearly bankrupt investment bank Bear Stearns six months earlier to a healthier bank, Lehman had been under increasing pressure. Like Bear Stearns, Lehman had invested heavily in sub-prime mortgages and other assets tied to real estate. And when Bear Stearns fell as its creditors began calling in its loans and other banks refused to lend to it, many wondered if Lehman would fall next.

In July 2008, Lehman reported a $2.8 billion loss for the second quarter of 2008 (the months April–June), precipitating a 54% fall in its stock price. As its share price fell, Lehman’s sources of credit began to dry up and its trading operations withered. CEO of Lehman, Richard Fuld, began a desperate search for a healthier bank to buy shares of Lehman and provide desperately needed funding. By early September 2008, Lehman’s loss for the third quarter had risen to $3.9 billion. On September 9, JPMorgan Chase, a far healthier investment bank that had been Lehman’s major source of financing for its trades, demanded $5 billion in cash as extra collateral or it would freeze Lehman’s accounts and cut off its credit. Unable to come up with the cash, Lehman teetered on the edge of bankruptcy.

In the September 12 meeting, U.S. Treasury Secretary Paulson urged the investment bankers to put together a package to purchase Lehman’s bad assets. But, fearing for their own survival in an extremely turbulent market, they refused unless Paulson would give them a government guarantee on the value of Lehman’s assets. The U.S. Treasury had made the Bear Stearns sale possible by arranging a huge loan from the New York Fed to its purchaser. This time, facing a backlash from Congress over “bailing out profligate bankers,” Paulson refused to provide government help. And in the wee hours of Monday morning, September 15, 2008, Lehman went down, declaring the most expensive bankruptcy in history.

Yet, as Fuld had earlier warned Paulson, the failure of Lehman unleashed the furies. That same day the U.S. stock market fell 504 points, triggering an increase in bank borrowing costs and a run on money market funds and financial institutions around the world. By Tuesday, Paulson agreed to an $85 billion bailout of another major corporation, the foundering American International Group, at the time the world’s largest insurer. Before the markets stabilized months later, the U.S. government made $250 billion of capital infusions to bolster major U.S. banks. Whether or not Paulson made a catastrophic mistake by not acting to save Lehman is a matter likely to be debated for years to come.

Quick Review

  • There is a trade-off between liquidity and yield. Without banks, people would make this trade-off by holding a large fraction of their wealth in idle cash.

  • Banks allow savers to make a superior choice in their liquidity–yield trade-off because they engage in maturity transformation. Savers can have immediate access to their funds as well as earn interest on those funds.

  • Since 1980 there has been a steady rise in shadow banking because shadow banks—non-depository financial institutions that engage in maturity transformation—have largely been unregulated, allowing them to pay a higher rate of return to savers. At the time of the Lehman failure, in the United States, shadow banking was about 1.5 times larger than the depository banking sector.

  • Because shadow banks, like depository banks, engage in maturity transformation, they can also be hit by bank runs. Shadow banks depend on short-term borrowing to operate; when short-term lenders won’t lend to a shadow bank, their refusal causes the bank to fail.

Check Your Understanding 17-1

CHECK YOUR UNDERSTANDING 17-1

Question 17.1

Which of the following are examples of maturity transformations? Which are subject to a bank-run-like phenomenon in which fear of a failure becomes a self-fulfilling prophecy? Explain.

  1. You sell tickets to a lottery in which each ticket holder has a chance of winning a $10 000 jackpot.

  2. Dana borrows on her credit card to pay her living expenses while she takes a year-long course to upgrade her job skills. Without a better-paying job, she will not be able to pay her accumulated credit card balance.

  3. An investment partnership invests in office buildings. Partners invest their own funds and can redeem them only by selling their partnership share to someone else.

  4. The local student union savings bank offers chequing accounts to students and invests those funds in student loans.

  1. This is not an example of maturity transformation because no short-term liabilities are being turned into long-term assets. So it is not subject to a bank run.

  2. This is an example of maturity transformation: Dana incurs a short-term liability, credit card debt, to fund the acquisition of a long-term asset, better job skills. It can result in a bank-run-like phenomenon if her credit card lender becomes fearful of her ability to repay and stops lending to her. If this happens, she will not be able to finish her course and, as a result, will not be able to get the better job that would allow her to pay off her credit card loans.

  3. This is not an example of maturity transformation because there are no short-term liabilities. The partnership itself has no obligation to repay an individual partner’s investment and so has no liabilities, short term or long term.

  4. This is an example of maturity transformation: the checking accounts are short-term liabilities of the student union savings bank, and the student loans are long-term assets.