Issue #7: What's Wrong With Our Banks?
The fractional reserve system has been making the rounds recently and it might just be in our best interest's to reconsider its position in our financial sectors
Hi everyone, welcome back. Firstly I would like to give a big thanks to all of you who read and shared the previous edition. With over three hundred views this was by far my most successful newsletter edition yet! In this week’s brief we’ll be having a look at what the hell happened in our financial sectors this week. As always, hope you enjoy.
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🧠 Food for Thought
What’s Wrong With Our Banks?
To say that this week was not an eventful one could be the greatest understatement of the year. Two of the largest bank failures in history just occurred this week. The tech focused bank Silicon Valley Bank and another bank called Signature Bank went under in a chaotic 48 hours where depositors withdrew $42bn, or a third of the SVB’s value, out of the bank in a classic run on the bank. This forced regulators to seize the banks and put them under their jurisdiction. Now, just a day later, Credit Suisse has secured a $54bn ‘“emergency loan” from the Swiss central bank to bolster market confidence in the country’s second biggest lender.
Why did SVB fail?
SVB and Signature Bank did not file for bankruptcy nor was it insolvent. So how did it not have enough money to repay its depositors? Well this all boils down to a liquidity problem or not having enough cash on hand to repay depositors as it was all locked up in long term investments. Specifically in government bonds.
Government bonds are usually the most strategic and safest assets anyone, including banks, can purchase. They are not risky and are usually the means by which banks create a strong risk averse portfolio.
Say you buy a government loan that returns 1%. This is what happened to SVB during the pandemic when interest rates were extremely low, but now the government raises the interest rate to 5%. Automatically, your bond is worth less on the bond market compared to the 5% loans over the same period of time. Now your bond isn’t even worth what you paid for it, it is worth even less. But this shouldn’t be a problem if you hold on to that loan until its maturity? In theory it shouldn’t but unfortunately it does when depositors demand their money. When the banks don’t have enough liquidity to repay depositors they are forced to sell these bonds and take a loss on proceeds. Thus we can see how a simple liquidity problem becomes a complex insolvency issue. One the US cant afford to deal with at the moment and that is why regulators had to step in and shut down the banks.
Are Funds Ensured?
Well are funds insured you may ask? Yes and no. The Fed is only obligated to insure up to $250k per bank account.
But as mentioned earlier, SVB as a bank, is mainly focused on tech startups meaning that accounts can run up to the millions of not hundreds of millions of dollars. As we can see a guarantee of $250k is not going to cut it. This is ultimately why the Fed stepped in and secured all deposits. In doing this they also aimed to calm down market sentiment, urging depositors not to do the same kind of thing on their own banks, thus preventing a spillover.
What Does the Fractional Reserve System Have to Do With All of This?
The answer quite simply, is everything. In the US, banks are only required to keep 10% of money received liquid. The rest, they can do what they please with it. This can be an effective tool in increasing the velocity of money around an economy which is essentially the ‘cashflow’ of an economy. But this does not come without some downside.
I would like to illustrate this with an example of what has become know as the Money Multiplier Effect:
Let's say a bank has $100,000 in deposits from its customers, and the fractional reserve requirement is 10%. This means the bank is required to hold 10% of its deposits as reserves, or $10,000, and it can lend out the remaining $90,000.
When the bank lends out $90,000 to a borrower, the borrower takes the loan and uses it to make a purchase, say of a car. The seller of the car deposits the $90,000 into their own bank account, which becomes a new deposit for that bank.
Now, that bank is also subject to the 10% reserve requirement, so it has to keep 10% of the new deposit, or $9,000, in reserves, and it can lend out the remaining $81,000.
The borrower who receives the $81,000 also spends it, and the seller of the goods or services who receives the $81,000 deposits it into their own bank account, creating another new deposit.
This process continues, with each bank holding onto a fraction of each new deposit as reserves and lending out the rest. As a result, the initial $100,000 deposit has created a total of $1,000,000 in new deposits throughout the banking system.
This is the money multiplier effect in action. The initial deposit creates a series of new deposits as banks lend out money and those funds are deposited into other accounts, resulting in a larger supply of money in the economy.
And the problem with this? Well its pretty obvious. If customers demand their total of $1,000,000 the banks only have $100,000 in liquid cash and if enough people demand their deposits back the banks are left scrambling to find ways to repay them.
So why did this all Happen in the First Place?
Ray Dalio makes a great observation as to why we are seeing exactly what we are seeing right now. That being the fact that we are in the early stages of an economic contractionary phase and that the amount of leveraged long holding of assets (ie. bonds) is large. I would like to encourage you all to watch his great documentary/ YouTube explainer called How The Economic Machine Works:
In the video he expands his theory on the business cycle and the contractionary and expansionary nature of economies in a cycle that lasts about 75 years. In the video he explains:
“I think that it is a very classic event in the very classic bubble-bursting part of the short-term debt cycle in which the tight money to curtail credit growth and inflation leads to a self-reinforcing debt-credit contraction that takes place via a domino-falling-like contagion process that continues until central banks create easy money that negates the debt-credit contraction, thus producing more new credit and debt, which creates the seeds for the next big debt problem until these short-term cycles build up the debt assets and liabilities to the point that they are unsustainable and the whole thing collapses in a debt restructuring and debt monetization”
Now what Ray seems to discuss here seems quite complicated, but when broken down it makes a lot of sense.
This extract is discussing a classic event in the short-term debt cycle. When the availability of credit is tightened in order to control inflation, it leads to a contraction of debt and credit through a domino-like effect that continues until central banks introduce easy money policies to counteract the contraction. This creates new credit and debt, which eventually leads to another debt problem, until the accumulation of debt becomes unsustainable and leads to a collapse and restructuring of debt.
Ray suggests that we are in the beginning of one of these contractionary phases and this is just the natural cycle of economies. So it does beg the question, if anything, what happens next?
What Effects Could this Have on the Rest of the Banking System?
It is not apparent what exactly could follow as we are in the early stages of assessing the fallout of the collapse of SVB and Signature Bank. Some suggest that when the Fed stepped in to secure all deposits they prevented further market panic and thus stabilizing the economy.
But this doesn’t mean that similar banks don’t face the same “liquidity to insolvency through government bonds” kind of problem. Credit Suisse, a bank that has long been considered on the verge of collapse, is facing a similar problem. They have acquired an emergency loan of around $54bn to steady the boat.
Again, this begs the question. Is all of this sustainable? Can we really keep on bailing out banks to calm down depositors in the long term? The bank has already lost 70% of its market value in the last 12 months. Surely that is a sign that investors aren’t optimistic towards the Swiss loaner?
The worst case scenario is that the collapse of SVB and Signature cause a domino effect around the entire economy triggering the collapse of Credit Suisse and more banks alike.
The best case scenario is that the loan secured by Credit Suisse and the insured money the Feds have given depositors at SVB steady the market and the banks can ride this contractionary cycle.
None of the two options sound like the post pandemic boom politicians were promising us, but rather that we are walking on eggshells every day, every second, of every hour. Banks in many ways have been off Washington’s radar, especially since the financial crisis. That all might change now.
💭 Thoughtful:
“Do the hard jobs first. The easy jobs will take care of themselves.”
Dale Carnegie
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-Luke