What is a bank ?

A bank is a strange and complex beast. It is a `remarkably versatile performer, taking on many roles across a wide spectrum of economic activity. They hold your assets — the most liquid and those less so — cash and term (deposits, albeit as an entry in a ledger). They constantly bet on the future — allowing people, corporations and institutions to invest and build today with a hope to reap a reward tomorrow (loans). In addition banks take advantage of the information, access and standing to engage in many other activities that span custody, trust, trading, risk management and execution. This piece focusses on the bread and butter activity that covers the core of deposits and loans.

Hard experience, learned over many years and innumerate crises, have taught us that the bets on the future don’t always work out, and even when they do they very seldom do so quickly. To avoid ruin a bank must hold enough safe liquid assets (liquidity) to meet any reasonable expectation of folks calling in their deposits (cash and near cash) and must limit the scale of their bets on the future (capital). Banking is subject to regulation. In the past, regulators were internal yet today they are external (perhaps in the future there is another way). The regulators impose restrictions on the scale of liquidity and capital required. Different types of deposits require different commitments from a bank in respect of liquidity (e.g. overnight deposits vs. 12 month fixed deposits). Different types of betting on the future require different commitments from a bank in respect of capital (e.g. credit card debt vs. mortgage debt). In the event of bank failure, be it as a result of insufficient liquidity or insufficient capital, the deposit holders ultimately have to look to the loans issued by the bank to meet their claims (once the capital is exhausted).

A bank is effectively a transformational service that uses client deposits and the bank’s own capital to make bets on the future whilst maintaining enough of a liquidity buffer to meet any reasonable reduction in the pool of client deposits. This is a complex and expensive activity, with many layers of management, plumbing, regulation and incentives. What if a bank, in its present incarnation, is not the best way to perform this function ?

A simpler and potentially more effective and efficient way to look at banking is as a series of Collateralised Debt Obligations (CDO). A CDO holds assets that are an underlying debt instrument or a pool of instruments (in our description above a bet or series of bets on the future) that is funded by the sale of one or more tranches of debt that have various claims on these underlying loans . In a simple example we could have a credit card loan for party A held by CDO GH that issues a funding tranche Z to party B. Party B would need to be comfortable that both their access to funds (liquidity) and ultimate repayment of capital and interest (risk) is directly linked to the performance of the credit card loan. This may not suit party B and in the absence of risk transformation both party A and party B will be stymied. Let us introduce party C. As before CDO GH holds a credit card loan for party A. Let us further assume that party A requires a loan for 80 units. CDO GH issues a funding tranche W to party B for 95 units. CDO GH further issues a funding tranche X to party C for 5 units. CDO GH has assets on its balance sheets of a loan for 80 units and net cash of 20 units. Tranche X and tranche W have very different features though. Tranche W allows party B to exit their investment at a date earlier than the expected maturity of the underlying credit card debt. If party B chooses to liquidate some or all of their holding of tranche W, then CDO GH hold liquid assets to meet some of this need and has an opportunity to seek a replacement investor, party D, for the balance. If party B wishes to liquidate some or all of its holdings of tranche W ahead of the contractual maturity of the tranche then party B may seek a replacement investor, party D, to buy tranche W. If the underlying credit card debt does not mature at par plus the agreed interest then the losses relative to the expected return must be borne by the holders of the tranches issued by CDO GH. In this instance, tranche X is a risk absorbing buffer that will suffer all the losses until extinguished. In effect, party B only suffers if the losses exceed the nominal of tranche X, namely 5. This mimics the behaviour of a bank. There is liquidity and capital. How much is needed ? A set of rules that defines what assets the CDO can hold and what tranches it may issue is effectively a regulatory framework. Not exactly simple, but So far so good. However what about the lender of last resort ? In the traditional banking environment the final risk absorption capacity is provided by the state. When a particular entity’s liquidity is exhausted or its assets are marked at levels that cannot meet its liabilities, the central bank (or its equivalent) can choose to step into the breach. This activity can limit the contagion risk of any single bank failure and calm the inevitable market schizophrenia. As an organ of the state this often leads to the risk being socialised i.e. effectively borne by all. Where is the benevolent actor in our world of CDOs? Is it needed ? We have robust rules and an assumption that all parties are adult participants. The moral hazard associated with “saving” private institutions has been an issue of late. How do we secure depositors money? How do we treat the bondholders and stockholders of the bank being saved? In the past we saved the bank not just the depositors given the key role played by the institution. If we are going to save anyone (and there is a robust debate to be had here) perhaps it should just be the depositors. We can recognise that the key role fulfilled by the bank as an activity (as opposed to the institution) can be replicated without any future obligation. As to whether there is a need for a lender of last resort, in a world where finance activity is transparent, leverage is known and all risk taking participants are adults, who exactly needs saving ?

This is not a new idea. Shadow banking has grown significantly. Structure and rules can deliver much but our model may be fragile and subject to contagion. Then again it may well offer a more robust, less expensive tool to facilitate leverage and risk, with gains and losses on offer for the adults in room.