Recent events have caused increased scrutiny of the banking sector; notably an interest in panics and runs. Let’s explore how banking is different from every other business, diving into the history of U.S. banking and why it differs from every other country.
Banking is Different
To understand banking, it’s important to understand the difference between what’s nominal and what’s real. Most people deal with the real world, which are physical things defined by their scarcity.
Take businesses, for example. They must operate within the real world, with real factors of production that require real things to deliver. These things include:
- Land and the natural resources used as the physical building blocks of goods or services
- Labor, in the form of employees or contractors to do the work
- Capital in the form of buildings and tools, and
- Entrepreneurs who take risks to put all the above together to form a profit.
Each of these factors has a market, and that market is defined by supply and demand.
In the real world, firms compete for goods and services, and scarcity acts like gravity to keep the entire system grounded. This makes it impossible to grow outwards forever without limit.
The opposite is true in the nominal world, such as banking and finance. The role of the financial sector is to arbitrage money, to take low-yielding debt and deploy that capital into higher-yielding debt. Here, the primary constraint is not supply and demand but abundance, which is how to manage money when there is too much of it.
There is an infinite demand for money, and to meet that demand, it is possible to overextend a balance sheet by making riskier and riskier loans, moving farther along a risk curve to reach for yield and make a profit. Every loan a bank makes creates money, and every bad loan destroys money. The cardinal sin of banking is making bad loans, and unfortunately, when there is too much money, the temptation for malinvestment is ripe.
What is a Bank? What is a Bank Run?
When banks issue loans, they essentially create money – not physically, by printing, but through an operating ledger (a demand for payment) in a telecommunications network, i.e., a spreadsheet everyone (the government whose money it is) agrees upon. There isn’t a warehouse or vault for storing this newly created money, but rather, a bookkeeper that keeps track of who owns how much currency and who owes what to whom and when (a loan).
Banks USED to be warehouses of money, as shown in the 1946 classic It’s A Wonderful Life, with the protagonists avoiding a bank run by supplying their own currency to meet the demand withdrawals of their depositors. This situation would be avoided today through FDIC insurance as the government steps in to provide the necessary funds instead of George and Mary Bailey. This outdated notion of banks having
physical money and being limited by reserve banking requirements (the money multiplier effect) required the Federal Reserve to issue a paper instructing economic textbook authors to cease its teaching, which is akin to having to relearn that Pluto is no longer a planet.
Today, a bank run does not involve depositors withdrawing physical currency. A physical bank vault is mainly empty and symbolic. Even the most prominent banks typically hold less than $200,000 in physical currency, not even enough to meet the full withdrawal request of a single FDIC-insured account. This is because physical currency does not generate interest like electronic deposits, so banks hold as little as possible.
Instead, a bank run would entail depositors updating their electronic ledgers to “move” their money from one banking institution to another. The money stays within the system, and liquidity is preserved.
During a crisis, one bank’s assets are usually transferred to another bank’s balance sheet with little consequence. Since problem banks’ assets are taken over by another firm, electronic ledgers are updated with little disruption, and order is maintained.
It’s important to note that banks are nodes within a greater monetary system that also includes pension funds, insurance companies, and other non-bank financial institutions.
Systemic Bank Failures
Major problems in the banking sector can generally arise in two ways.
Liquidity between nodes in the system Cash does not leave the system; instead, there is an issue with some plumbing. The 2008 Great Financial Crisis saw nodes stop lending to each other for fear of repayment since nobody wanted to be the one to hold so-called toxic assets. Firms were left with a mismatch between assets and liabilities that ballooned in size, and there was no larger institution to update the ledgers to. This created the idea of being “Too Big To Fail,” and new tools were designed, such as the Troubled Asset Relief Program (TARP) and Zero Interest Rate Policy (ZIRP), to get the plumbing between nodes to work again.
Liquidity out of the entire system When money flows into the system, such as fiscal stimulus during a pandemic, increased exports (like LNG) or lower interest rates or lower lending standards, banks will (usually) issue increased loans (of increasing riskiness) to deal with this large surge in the money supply. This can balloon a bank balance sheet and may lead to speculative bubbles. Eventually, money will leave the entire system if tightening occurs, i.e., interest rates/ taxes go up, or there is a surge in imports, and risky assets begin a coordinated selloff as they are the first loans to go bad. This started in 2018 as the Fed began tightening right before the pandemic, leading to the famous “Powell Pivot.”
Why are there so many Banks?
If banks are just nodes in a financial system, replaced seemingly without consequence, and who offers a fungible product in a super competitive field, why were there 4,715 FDIC-insured banks at the end of 2022? Wouldn’t fewer banks make sense?
This is the case for many other advanced economies; Canada only has 77 banks, with the six largest banks having over 90% of the market share, Australia only has 97 banks, and the U.K. has only 365 banks.
While the U.S. has more banks than any other country, this number has been greatly reduced over the past 100 years. At its peak in 1920, there were over 30,000 banks in the U.S., a number that was significantly reduced by the Dustbowl and Great Depression.
Since the 1920s, the population of the U.S. has roughly tripled, and the number of banks has decreased by 7/8th from its peak.
Since the mid-1980s, the number of banks declined considerably due to the Interstate Banking Act of 1985, which enabled banks anywhere in the country to establish a bank in any other state. This allowed bank consolidation to take place, causing the number of FDIC-insured banks to decrease every year since.
But again, why does the U.S. have so many banks relative to other advanced economies?
The answer is that most banks in the U.S. are regional and local banks that serve a local community’s needs, with agriculture and commercial real estate lending region specific. These are bespoke loans where the local lender knows the dirt and the specific market cycles that impact the local community. You need to know what you are lending on and take appropriate collateral, which is why the CRE loan book for small banks outpaces large banks.
Conclusion
In the 2008 GFC, the U.S. government picked winners and losers with extraordinary measures to prevent systematic bank failures. This was a failure to transfer money between nodes within the banking system. If there is another systematic bank failure, it will likely take another form due to the processes implemented after the GFC to strengthen the banking sector. Liquidity out of the system is a different problem that should be watched more closely.
The failures of Silicon Valley Bank gave an implicit guarantee to insure all deposits, and this protection may not extend to smaller banks as the safety net is untested at this point. Regulators in a crisis will likely make exceptions for larger banks (systematically important financial institutions) that will not be offered to smaller regional banks.
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