Money Stuff, by Matt Levine: Banks

Old_Joe

We talked last Thursday about two theories of banking, which I called Theory 1 and Theory 2. Theory 1 is that banks borrow short to lend long: Bank deposits are short-term funding, they get paid a variable market rate of interest, and they can disappear overnight if depositors worry about a bank’s stability or just get a better deal elsewhere. Theory 2 is that banks actually borrow long to lend long: Bank deposits are part of a long-term relationship, and much of what banks do — build branches, cross-sell products, offer ATMs and online banking — is designed to make those deposits sticky, so that their cost doesn’t go up when interest rates go up. Theory 2 is the traditional theory of banking; it’s why there are branches. Theory 1 is the standard theory of modern capital markets; it’s why, when Silicon Valley Bank failed due to taking too much interest-rate risk, lots of people were like “how did they not see that coming” or “why didn’t they hedge?”

Part of my goal on Thursday was to try to answer those questions, to suggest that Theory 2 really is kind of how banks (and bank regulators) think about the problem. (“Why didn’t they hedge their interest-rate risk?” Well, they had long-duration liabilities, in the form of deposits, and they matched them with long-duration assets, in the form of Treasury and agency bonds, so they were hedged; they just got the duration of their deposits wrong.)

And part of my goal was to think about why Theory 2 stopped working in 2023, why deposits weren’t sticky, why banks like Silicon Valley Bank and First Republic Bank faced massive runs and disappeared when rates went up. My speculations included better availability of information (bank deposits used to be sticky in part because it was harder to pay attention to them), a more widespread mark-to-market financial culture, the hangover of 2008, and the decline of relationship businesses generally:

In a world of electronic communication and global supply chains and work-from-home and the gig economy, business relationships are less sticky and “I am going to go into my bank branch and shake the hand of the manager and trust her with my life savings” doesn’t work. “I am going to do stuff for relationship reasons, even if it costs me 0.5% of interest income, or a slightly increased risk of losing my money” is no longer a plausible thing to think. Silicon Valley Bank’s VC and tech customers talked lovingly about how good their relationships with SVB were, after withdrawing all their money. They had fiduciary duties to their own investors to keep their money safe! Relationships didn’t matter.

One thing that I would say is that if this is right and you take it seriously, then it is pretty bad news for US regional banks. “Banking is an inherently fragile business model” is a thing that people say from time to time (when there are bank runs), but nobody quite means it. They mean something like “from a strictly financial perspective, looking at a balance sheet that mismatches illiquid long-term assets with overnight funding, banking is insanely fragile, and the whole business model of banking is about building long-term relationships with slow-moving price-insensitive depositors so that the funding is not as short-term, and the business is not as fragile, as it looks.” But if the relationship aspect doesn’t work anymore, then banking really is just extremely fragile. Without the relationships, banks are just highly levered investment funds that make illiquid risky hard-to-value investments using overnight funding. That can go wrong in lots of ways!

At Bits About Money last week, Patrick McKenzie had a deep dive on Theory 2, on “Deposit franchises as natural hedges.” He lays out why banks thought that they could take a lot of interest-rate risk despite their short-term funding; he explains the theory that a deposit franchise — the relationship that banks have with their customers that allows them to keep deposits even as rates go up — is a valuable thing and a natural hedge against rising rates.[5] And he too speculates on why that didn’t work as well as they expected. He is, I think, more pessimistic than I was:

For retail, for a period of years—years!—we took the sweat and smiles business, the work of literal decades, and we—for the best of reasons!—said We Do Not Want This Thing. That very valuable thing was, like other valuable things like churches and birthday parties and school, a threat to human life. And so we put it aside. We aggressively retrained customers to use digital channels over the branch experience. We put bankers at six thousand institutions in charge of teaching their loyal personal contacts that you can now do about 80% of your routine banking on their current mobile app or 95% on Chase’s. And then we were shocked, shocked how many people denied the most compelling reason to use their current bank and shown the most compelling reason to bank with Chase switched.

With regards to sophisticated customers, the answer is not primarily about mobile apps or how difficult it is to wire money out of an account. It is about businesses making rational decisions to protect their interests using the information they had. Sophisticated businesses are induced to bring their deposit businesses, which frequently include large amounts of uninsured deposits, in return for a complex and often bespoke bundle of goods they receive from their banks. The ability to offer that complex and bespoke bundle is part of the sweat and smiles of building a deposit franchise. …

Why did they suddenly trust their banks less about the near-term availability of the bundle? Contagion? Social media? I feel these are misdiagnoses. Their banks suffered from two things: their ability to deliver the bundle was actually impaired. They had “bad facts”, in lawyer parlance. Insolvency is not a good condition for a bank to be in.

And those bad facts got out quickly, not because of social media and not because of a cabal but simply because news directly relevant to you routes to you much faster in 2023 than in 2013. There is no one single cause for that! Media are better and more metrics-driven! Screentime among financial decisionmakers is up! Pervasive always-on internetworking in industries has reached beyond early adopters like tech and caught up with the mass middle like e.g. the community that is New York commercial real estate operators.

The whole relationship aspect of banking is devalued; rational economic decisionmaking based on mark-to-market asset values has become more important. This makes banks fragile. What makes banks something other than highly levered risky investment funds is their relationships, and that support is weakening.

Elsewhere at Substack, here is Byrne Hobart on “ The Relationship-Transactional-Relationship Business Cycle,” which is I suppose more optimistic:

Transaction economics include the flow of object-level decisions—do we buy this Google click, spin up that EC2 instance, or accept this Stripe transaction—and a stock of expectations and trust slowly built up on both sides. It's essentially a form of reputational capital, and a company that's betting most of its revenue or operations on a counterparty that they can't have a conversation with is, in some abstract sense, undercapitalized.

catch22

A tangent for regional banks and credit unions; not the large investment banks.
Our cu and area banks are still offering .2% more or less for a standard yield for a saving or checking account. Our credit union has a 'high yield' checking account with a yield of 4.15%, on the first $10K......but one must have 15 transactions each month on the account (debit card transactions, etc) and also be set up for paying bills electronically.
The CD rates are very low, too.
Only thinking out loud with words that one would think there are 'x' number of transactions at our credit union and/or banks where there is a decent profit spread between what is being paid depositors and loan profits for vehicles.
With a high quality credit rating the credit union's loan rate for a 2019 - 2023 vehicle is 5.54% for a 48 month period. A very large profit spread, eh; if the loan doesn't default.

Sidenote: Tis recently reported that the average new vehicle MSRP is $46,000. Considering our cu's 48 month loan rate, one finds a $1,081 monthly payment. YIKES. I have not attempted to discover the current loan default rate for vehicles. Additionally the cu's and banks are competing with low loan rates from the manufactures and their lease programs, too.

Conclusion, I suspect, is how much profit is really being made with these type of loans for regional banks and cu's.