Bank Runs

I want to provide a little background in order to better digest the news headlines about bank runs / the current “banking crisis”.  The first thing is to know is that banks MUST hold some cash to cover depositors.  Banks can hold that money in the form of “cash equivalents”… US Treasury Bills (T-Bills) and MUST keep at BARE MINIMUM at least 10% of deposited money in their vaults as cash equivalents (their vault is a number on a computer screen).

The awesome power of a bank (by virtue of the regulators granting a “banking license”) is that it can create money out of thin air!  This is how it happens: A bank can issue a loan, by writing an “IOU” on a piece of paper, to anyone they deem “credit worthy”. Often they’re just middle persons that sell those IOU’s to the US Government (for example Fannie Mae / Freddie Mac) or other wealth funds & investors.  The bank does not actually possess this money they lent out, it is YOUR money (money they hold from their depositors). But then consider, is it “your money”?  Do you have a mortgage?  Then a lot (or all) of that money you have in “your bank account” actually is owned by the “investor” that holds that proceeds from your mortgage. Do you know who “owns” your mortgage debt? Most people don’t.

So “your money” at your bank, which your bank lends out to someone else, isn’t actually your money since it is owed to whoever owns your mortgage IOU / debt.  This process goes on and on, with each loaned dollar becoming a deposit at some other bank, which that other bank loans out to someone else, which becomes a deposit at some other bank… and so on.  This is how the banking system creates money out of thin air… and how the Federal Reserve (i.e. US Central Bank / Jerome Powell) tries to control the money supply, and with that, inflation.  IF one bank in that chain of loans becoming deposits… makes very bad loans, we get 2008-2009 & “Globally systemic” banks that must not be allowed to let this system unravel (i.e. Dodd Frank).

HOWEVER, remember that banks must keep at least 10% of the money they have “loaned” (that they did not sell to the US Government, wealth fund, or other investor) in their vault (i.e. number on a computer screen).  These loans are usually business loans and other loans to members of the bank’s community, that the bank retains as a liability on their balance sheet.

These loans that the bank retains (i.e. does not sell off to investors) must be backed with “real money” and not as an IOU or piece of paper. AT BARE MINIMUM, the bank needs to retain 10%.  They hold more than 10% because if they dip below 10%, game over!  They lose their banking license or are in big big trouble. Here’s where Silicon Valley Bank & Signature Bank went wrong. Let’s try to illustrate this with a story:

Let’s say you are a bank and operating the above business of making loans. You lend out other people’s money because the regulators & community trusts you!  So your friends in the local community, deposit money with your bank. You then make loans, and can sell those loans (and credit risk) to other parties (for example, you’d sell your mortgage loans to Fannie & Freddie).  Collect your underwriting fees, rinse and repeat!!  Its a solid business model that most banks do, especially with mortgages because Fannie & Freddie will ALWAYS buy that loan (if it meets their criteria, which is how pretty much all mortgage underwriting is done):

Its fun to think that if George Bailey (Its a Wonderful Life) ran a bank today, the scene attached to this article would never happen. George would have sold those loans to Fannie Mae or Freddie Mac (Banks usually choose one to do business with). But moving on….

While selling mortgages to Fannie & Freddie is nice, it doesn’t make you that much money. In fact, the profit margins are really low.  You need more!  Your banking operation could also include riskier operations such as business loans to some smart friends you know, that are creating a company to open a grocery store in a near by food desert! You think they’ll do very well since there’s no grocery stores within miles of their proposed location. They need a loan to get started, however, you will NOT be able to sell this loan to anyone. No enormous wealth funds are interested in purchasing the debt obligations of a small local grocery store.  So, you make the loan… and charge enough interest to cover the risk… or so you think!

You were able to do this because Georgene, a member of the local community, deposited $1 million in your bank. So you were able to give your friends $800K of Georgene’s money to start their grocery store.  You are being a good banker and making money off other people’s money, and of course you give Georgene some great perks as a “wealth management” level client. All is well.  You have $200K of Georgene’s money in the vault (i.e. number on a computer screen), and the rest of Georgene’s $800K exists as an IOU from the grocery store.  You have TWICE as much in the vault than is required (i.e. 10% of Georgene’s original $1 million they deposited in your bank).

But, let’s say YOU WANT MORE!!!  You then take that $100K of Georgene’s money that exists in the vault… and buy US Bonds maturing in 10 years that pay a higher interest rate than if you just kept it in T-bills or as stupid cash.  Hey, it’s a US Bond! If you need to, you can sell it and everything will be fine. You’re a great banker!  You have $100K of  Georgene’s deposits as cash meeting the bank regulator’s 10% rule, and another $100K of Georgene’s deposits as US Bonds, which are “safe”!  You’ll be fine, you tell yourself.

Fast forward 14 months later and the Federal Reserve has increased the FED Funds Rate by 4.75%!  Your fancy consultants said this is a 6 standard deviation credit event with a 2 in a billion chance of occurring!  But it did.  And now Georgene wants $100K of their money because they see opportunities in bond investments they’d like to gamble in.  But you don’t have that money!  Its in a US Bond that is worth A LOT less than what you purchased it for.  So you sell the US Bond at a loss of 25% and the $100K you purchased the bond for turns into $75,000!  Georgene initially deposited $1 million, took back $100K of that and has $900K deposited at your bank. You have to have at least $90K because that’s what the bank regulations require, and if you don’t do it… you go to jail!  Oops… You have to go into the vault and get $25,000 to give to Georgene their money back… which only leaves $75,000 in the vault to cover Georgene’s $900K in deposits!

Now multiply this by… 100,000 Georgenes.  And also, turn those friends opening a grocery store into a company that is creating an App that will add bunny ears to your photos and doesn’t have a way to generate that idea into money… AND add onto this that their app can only be accessed via Ethereum transactions.  That was Silicon Valley Bank. I exaggerate, but hopefully it paints a picture.

The banking regulations after 2008-2009 via Dodd-Frank was designed to help protect against this event.  However, Dodd Frank was repealed on May 24, 2018. And, banking stress tests did not, and do not… include factors to protect against the Federal Reserve increasing interest rates faster then ever before in the history of the USA.  So even with Dodd Frank, this problem would have probably materialized.  In our example above, the “YOU WANT MORE!!” step, of holding excess banking reserves in long term duration bonds, would have caused this problem.  Also, the SPEED of banking is amazing. We as a society can move money faster than ever before. Imagine closing a bank account in the 1990’s… you’d have to physically go to a different bank, open up an account, then go back to your previous bank, get that money, then carry the cash over to the new bank…etc.  Whereas now, with the click of a button, the money moves.  That’s how the 16th largest bank in the USA closed overnight.

The major pain that banks are feeling is that they ALL did some form of the “YOU WANT MORE” step, in varying degrees. The banks that did very little or none of holding excess bank reserves as long term bonds, are fine.  The banks that DID, are probably very worried. Those longer term bonds they purchased aren’t going to vanish.. they’re like a house you might have purchased 2 years ago that is worth 25% less than what you paid for it right now… and the full balance of the mortgage might be called in any day!

If bank fears escalate, the Georgene’s of the world will NOT want anything more than the $250K FDIC insured amount at any bank.  Right now it seems that the US Government is wanting to stepp in and increase the FDIC limits to prevent bank runs / fears from spreading, so that the Georgene’s of the world will not remove amounts over the $250K insured amount from their various banks, brokerages, etc.  THIS IS NOT FINANCIAL ADVICE: I personally don’t think this is a systemic banking issue. We all know what is happening, and the US Government & Federal Reserve (And other Governments & Central Banks, like the Swiss) have unlimited power to insure / create money to prevent a reoccurrence of 2008-2009.  Again, this is not financial advice, anything can happen.

P.S. Our 401K funds are disbursed by a Trust Company, that does not make loans.  There are also no deposits as your 401K assets are held in securities (i.e. stocks & bonds), and the “cash” portion of your 401K is held in “money markets” (i.e. T-bills & cash equivalents referenced above).  Also your funds are insured by SIPC.

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