Banks cannot behave like start ups using a business model based on short term profits
Banks are betting on short-term profits, and this is leading to their collapse. If we don’t want to lose our small players, like we did with SVB, we need to recapitalise banks, writes Hugo Llewelyn
In ancient Greek, economics means simply the “law (nomos) of the house (oikos)”. The analogy of how we finance home purchases is useful to understanding current fears about the global banking system – and the changes that need to be made to make it more sustainable.
Consider a house that was purchased for £400,000 with a 70 per cent LTV mortgage on fixed rate, amortising terms over a 25-year duration. The value of the house may fluctuate but as long as the owner can not be required by the lender to sell it assuming the loan is being repaid; and can pay the interest and repayments on the loan, then over the long term the debt will be repaid. This leaves real equity value to the householder’s account.
By contrast, consider a financing deal for the same £400,000 house, where the owner borrows using an 85 per cent LTV mortgage on floating rate terms, of which say 50 per cent of that mortgage can be demanded by the lender at any time for any reason, on short notice. This is essentially where banks are at today.
The highest equity ratios of mainstream banks at the current time are around 15 per cent of total asset value. This means that a bank with $3tn of assets might have liabilities of around $2.6tn and a market capitalisation of a significant percentage of the difference, though that is largely irrelevant given the level of gearing and the effect of percentage movements in asset values. A 15 per cent fall in the bank’s assets would wipe out equity here.
Banks make a healthy chunk of their profits on equity from borrowing at deposit and interbank rates and lending out longer-term at higher rates. Those deposits are often repayable on a short-term basis, so the confidence of depositors is key to a bank’s ability to make profits and keep lending.
If the financial turmoil we are witnessing deepens, and more banks reveal their mismatch in liability and asset durations, what we will see is depositors fleeing from smaller institutions to those deemed ‘too big to fail’. They will offer lower deposit rates and charge higher rates to lend to others, so increase their profits materially. The smaller banks face being bought by the larger ones.
This has wider implications for the economy. A reduction in the number of banks lending and taking in deposits is negative for the financial markets for both competition and pricing.
Simply put, in nearly all cases, banks need to be less leveraged and better capitalised with equity. Like our housing example above, an equity ratio of 30 per cent of assets might be more appropriate, combined with longer duration deposits paying a slightly higher rate. This would lead to less short-term profit on equity and short-term rewards for management, so would need coordinated government regulation to enforce.
This is in the long-term interest of all bank stakeholders, including shareholders. The short-term profitability of SVB did not stop its shareholder equity being wiped out and no annual dividends, however progressive, will compensate for that.
It is not all downside either: higher profits of the surviving banks after this crisis will reduce the dilutive impact of enforced equity raising.
Governments cannot rest on their laurels. Increasing levels of deposit insurance, as currently proposed, will not have a material impact for larger depositors while transferring risk from the private sector to the public. A recapitalisation of banks is needed – or the whole financial system risks becoming a house of cards that collapses.