He who panics first, panics best!

Asset/Liability Funding Mismatches: The Major Cause of Institutional “Runs on the Bank”

Modern day banking business models (fiat banking system) fund business investment that often require expenditures in the present to obtain returns in the future (for example, spending on machines and buildings now for production in future years). Therefore, when businesses (banks included) need to borrow to finance their investments, they usually do so on the understanding that the lender will not demand repayment(s) until some agreed upon time in the future. Usually, the farther into the future, the more preferable, thus entities with exposures to business cycles (businesses) often prefer loans with a longer maturity. This longer maturity leads to lower liquidity, which is in the better interests of the borrower. This very same principle applies to individuals seeking financing on the purchase of big ticket items such as real estate, housing, boats, small businesses and cars. The flip side of this equation contains the primary funding source in the fiat banking system, the individual savers (both households and firms). These savers strive for relatively high liquidity due to shorter cycles in their (sometimes sudden) and considerably less predictable needs for cash. The products that serve these needs are the demand accounts that commercial banks use as their primary funding source.

Commercial and investment banks (as well as some broker/dealers) profit by acting as intermediaries between short term savers who prefer highly liquid demand accounts and borrowers who prefer to take out long-maturity loans with considerably less liquidity. When things are working as anticipated in the fiat banking system, banks acting as intermediaries profit by channelling capital from short term savers to long term borrowers, underwriting and eating the risk of this “asset liability funding mismatch”.

Banks also carry on their capital intensive businesses (ex. trading, market making, etc.) in a similar fashion by borrowing heavily on the short end of the yield curve on a relative sliver of equity and investing in the longer end of the curve or in more volatile, risky asset classes (i.e. public equities, private equity, real assets, commodities, etc.)

The premise behind the fractional reserve (a system where only a fraction of deposits are required to be kept in house as reserves against deposit demands)/fiat banking system is that under ordinary circumstances, savers' unpredictable needs for cash are unlikely to occur at the same time. This premise has been justified by the theory that depositors' needs reflect their own and mostly unique individual circumstances. The fiat/fractional reserve banking institution, by accepting deposits from myriad and differing sources, assumes risk has been effectively diversified away, with the bank expecting only a small fraction of withdrawals in the short term at any given time. This is despite the fact that all depositors have the right to take their deposits back at any time. Adherence and acceptance of the logic behind the fractional reserve system allows fiat banks to make loans and investments over a long horizon, while keeping only relatively small amounts of cash on hand to pay any depositors (and counterparties) that wish to make withdrawals, capital calls or collateral calls.

Traditional views on this “bank run model” largely (or more aptly, only) consider individual savers in the form of depositors on the short side (liquid liabilities). It is a run such as this that caused the banking collapse during the US Great Depression. The modern central banking system has proven resilient enough to fortify banks against depositor runs, as was recently exemplified in the recent depositor runs on UK, Irish, Portuguese and Greek banks – most of which received relatively little fanfare. Where the risk truly lies in today’s fiat/fractional reserve banking system is the run on counterparties. Today’s global fractional reserve bank get’s more financing from institutional counterparties than any other source save its short term depositors. In cases of the perception of extreme risk, these counterparties are prone to pull funding are request overcollateralization for said funding. This is what precipitated the collapse of Bear Stearns and Lehman Brothers, the pulling of liquidity by skittish counterparties, and the excessive capital/collateralization calls by other counterparties. Keep in mind that as some counterparties and/or depositors pull liquidity, covenants are tripped that often demand additional capital/collateral/ liquidity be put up by the remaining counterparties, thus daisy-chaining into a modern day run on the bank!

This phenomena essentially discredits the thinking at large and currently in practice that “since individual expenditure needs are largely uncorrelated, by the law of large numbers” banks should expect few withdrawals on any one day. The fact of the matter is that in times of severe distress, particularly stemming from solvency issues (read directly as the Pan-European Sovereign Debt Crisis, and Greece, et. al. in particular), the exact opposite is the case. Individual depositor and counterparty actions are actually HIGHLY correlated and tend to move in tandem, particularly when that move is out of the target fiat bank. They tend to take heed to the saying “He who panics first, panics best!"

Asset/liability mismatch can, at the margin nearly assure a Lehman-style fiasco in the case of an impetus that sparks herding mentality, whether it be among depositors/savers or institutional counterparties.

Since banks both lend out and often invest at long maturity, they cannot quickly call in their loans or sell their investments. This scenario is exacerbated when said loan and/or investments have materially dropped in value causing a capital gap in between what said loans/investments can be called in for, and what is actually owed to the short term creditors. Again, this is a perfect example of what happened in the US with AIG, Lehman Brothers and Bear Stearns. Therefore, if a significant portion of depositors or counterparties either attempt to withdraw their funds or raise collateral/capital requirements simultaneously, a bank will run out of money long before it is able to pay all of its short term the depositors. The bank will be able to pay the first depositors who demand their money back, but if all others attempt to withdraw too, the bank will be realized insolvent and the last depositors will be left with nothing. It is for this reason that short term creditors tend to “panic first” in an effort to “panic best”, leading to a chain reaction that perpetuates a bank run. Essentially, the fiat/fractional reserve banking system creates a self-fulfilling prophecy wherein each depositor/counterparty's incentive to withdraw liquidity and funds depends on what they expect other depositors/counterparties to do. If enough depositors/counterparties expect other depositors to withdraw their funds, then they all have an incentive to rush to be the first in line to withdraw their funds. “He who panics first, panics best!"

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