Creditflux Newsletter

Amidst the clamour for regulatory reform of banks, it’s stunning that few people give voice to the dominant cause of the credit crisis: the financial world’s deadly combination of high leverage and the deliberate maturity mismatch between assets and liabilities. More and “better” regulatory rules cannot diminish the banks’ risk of failure unless such rules call for a dramatic reduction in leverage and much better asset-liability matching.

Banks take deposits from retail customers and lend these and other borrowed funds to corporate and consumer clients. The deposits are bank liabilities that can be withdrawn daily. Thus, such liabilities are potentially of very short maturity. In an attempt to prevent “bank runs”, central banks and governments impose operating rules and provide liquidity facilities and deposit insurance.

But this is the wrong regulatory approach. Bank deposits should not be a funding source for lending. Banks and other institutions that take retail demand deposits should run this activity with a 100% reserve requirement rather than the current 10% requirement (in the US). This move would constitute radical and wrenching change, but it would prevent losses to depositors.

Two clear consequences of this reform would be that depositors would earn zero or negative interest and banks would need other borrowing sources in order to extend loans. Regarding the former, the zero/negative interest rate is appropriate for customers who desire zero risk and continuous access to their cash. Indeed, the current promise to depositors of positive interest with zero risk and immediate access to cash is unsound.

Prohibiting banks from lending the funds they receive from retail depositors would disrupt bank lending. But the short maturity of retail deposits makes them improper and unstable as funding for longer term loans. Prohibiting the use of deposits as funding for loans would solve the problem of bank instability. Banks and other lenders would then simply need to borrow separately in order to make loans.

The separate borrowing methods available to banks include commercial paper, bonds issued to the public, and collateralised loan obligations (CLOs) sold to sophisticated investors. Prudent risk management would match the maturity of funding to the maturity of lending. CLOs stand out as being remarkably robust by this measure since the repayment of the loans directly repays the CLO funding. The CLO, then, is a market innovation for sound lending.

In this new framework, which would decouple bank deposits from bank lending, there is a straightforward solution to the “too big to fail” problem because any bank could fail. The bank depositors would take zero losses since they would be entirely protected by segregated funds (as required under the 100% reserve requirement). Bank debt and equity investors would lose out from time to time, but there is no public policy imperative to protect them.

When a bank sinks into bankruptcy, the market would of course have lost a lender. But as in any sector, the loss of one participant provides opportunity for others. It is only the traditional connection with bank deposits that gives rise to the too-big-to-fail problem. The business of lending need not be dominated by a small number of firms.

Joe Pimbley is a financial consultant in his role as principal of Maxwell-McDevitt Associates. His expertise includes enterprise risk management, structured products, derivatives, and quantitative modelling. Comments, encouragement and critical denunciations are welcome
at pimbley_mcdevitt@msn.com.