Banks Have Too Much Money, But Not Enough
Dolors & Sense
by Sanford Rose
KISSIMMEE Florida—(Weekly Hubris)—10/3/11—It’s the difference between cash and capital.
In a bank, cash is other people’s money; capital is the bank’s money.
Banks have too much of the former (mostly deposits), not enough of the latter (mostly loss reserves and retained earnings).
It can be argued that the reason they have so little of their own money is that they have too much of other people’s money. Excess leverage encourages risk.
In a bank, risk is mostly of the credit and interest-rate variety. In the 70s and early 80s, most banks were bankrupt because they assumed too much interest-rate risk, which is defined as mismatching the yield maturities, or durations, of assets and the liabilities that finance them.
Since 2007, most are bankrupt because they assumed too much credit risk.
Ironically, the banks didn’t know, in the current bankruptcy cycle, that they were taking on too much credit risk. Mortgages were “safe.”
They did know, however, that they were assuming a fair amount of interest-rate risk since many financed their long mortgages, which were housed in special investment vehicles, with short commercial paper.
When the crisis broke, the short commercial paper deserted them. Suddenly, emerging credit risk exposed the vast amount of interest-rate risk and culminated in a liquidity crunch, the likes of which the system had not experienced in seven decades.
Today many banks are once again assuming huge interest-rate risk as they “play the yield curve” in an effort to rebuild the profits lost in the mortgage bust.
But they eschew credit risk, especially consumer mortgages.
The ostensible reason is that the consumer is overleveraged—that is, the ratio of consumer borrowings to net worth, though declining, is still too high.
Yet, if banks properly valued their legacy mortgage paper, their own net worth would evaporate, and thus their leverage would approximate infinity—a trifle loftier than that of the consumers to whom they are so disposed to preach.
Banks need to return to the consumer market, using henceforth more of their own and less of other people’s money. To create that capital requires a kick-start from the Government, probably in the form I suggested on September 19.
Sanford Rose
Sanford Rose, of New Jersey and Florida, served as Associate Editor of Fortune Magazine from 1968 till 1972; Vice President of Chase Manhattan Bank in 1972; Senior Editor of Fortune between 1972 and 1979; and Associate Editor, Financial Editor and Senior Columnist of American Banker newspaper between 1979 and 1991. From 1991 till 2001, Rose worked as a consultant in the banking industry and a professional ghost writer in the field of finance. He has also taught as an adjunct professor of banking at Columbia University and an adjunct instructor of economics at New York University. He states that he left gainful employment in 2001 to concentrate on gain-less investing. (A lifelong photo-phobe, Rose also claims that the head shot accompanying his Weekly Hubris columns is not his own, but belongs, instead, to a skilled woodworker residing in South Carolina.)