Talking more about banks and what they do.
Regular readers might remember this diagram, of the structure of a bank. I try to present this in a way that non-accountants will be comfortable with it; but, if you have a problem with geometry, you might be a bit screwed.
On the right hand side, you have the liabilities of a bank, which are usually the deposits you have taken, and any other kind of borrowings you, as a bank, have done from others. This side also includes the money that the actual owners of the bank have either put in or that the bank has earned for them. Right? So a CD will show up as a liability. A share of stock will also show up on the liability side, even though it is considered “equity”. Profits that a bank makes, that are kept, are also on this side.
On the left side, are the banks assets. This is mostly the loans that the bank has made, but it also includes the cash it holds. It also includes any “securities” that the bank owns for itself–so called “proprietary accounts”. The last time I used this chart, I was maybe discussing about how bad loans are a hit to equity. On the bottom of the left side, I show that when loan repayments are questionable, the bank has to cut down the size of the rectangle, and report the loan as a net. To make both left and right sides even, that cut down is going to mean an expense of the right-hand side, and that will reduce income; meaning, it will reduce equity.
Today, though, I want to talk about what happens with CASH.
For the longest time, cash that a bank held could get a return of at least some decent amount, just because America’s central bank—the Federal Reserve—was paying interest of, say 5%. Back in the late 1970’s, this was more like 10%, due to inflation. When prices are going up 10% a year, cash balances look to earn 10%. Otherwise, you put the money into the things you need to buy, while they are still cheaper than they would become in a few months!
Nowadays, though, cash pays virtually zero. Or, it pays something close to zero, starting out with zero, like 0.25%.
A bank sitting on a lot of cash doesn’t like that, because they have taken in deposits—maybe even at zero percent themselves—and getting zero means they really earned nothing for the shareholders.
They might not want to put the cash out as loans, because there aren’t opportunities. They need return OF capital as much as return ON capital. They need to know the loans are going to be paid back. Lending to the government, which I mentioned yesterday, is not as appealing, because the government bonds only pay 2% or 3%. This is, if the bank locks up the money for 10 years, or 30 years.
So the bank decides that it’s going to do a little trading, betting, and speculating. To make it acceptable, they call it “hedging”. They point to some risk on the balance sheet—which is always present because it’s a bank! They say, “we need to do this, because there is this other risk on our asset side, that we would like to reduce.”
Normally, when you are an investor and you want to reduce a risk, you sell the asset. You do not go and enter into some other agreement that is meant to go in the opposite direction of whatever the risk is that you are worried about. (That is, go up when you think the other thing will go down.) Usually, you get rid of the thing that you fear will go down, by selling it to a willing buyer.
Banks, actually, are supposed to be “hold to maturity” institutions. They are “financial intermediaries” that take business’ everyday deposit money (demand money, that you can have on demand), and they turn that into 30-year mortgages or 10-year loans to companies. The idea that a bank is there to take deposit money, and then use it to “hedge” is somewhat new and alien to the occupation. Sure, some kinds of hedging go on with all businesses. But that hedging is its own thing; especially, that it is meant to reduce inherent business risks, is something that contemporary finance people have told themselves, and each other, to justify big salaries and bonuses.
Ina Drew is not the first person, by any means, to be working with “innovations” and cashing in, until the model doesn’t work.
I remember when I worked for CoreStates (Philadelphia National Bank) in the late 1980’s, asset-liability management was all the rage. Bank people thought they had reached nirvana, when they realized you could reduce risk by matching 3-year certificates of deposit “in”, with 3-year loans of money out the door. You charge more to the borrower than you pay the depositor, and you’ve “locked in” the profit to the bank for three years. This is, so long as the loan is paid back.
The problem they had, inevitably, was that more sophisticated lenders, who were willing to slice out a lot of the middle-men (the officers and all that office space), came in and ate at the CoreStates model. They lent for a lower rate, and then it didn’t matter that people were tracking the terms of money in and money out on a PC. Most of the big money people working for that bank weren’t needed, and they were lucky to get a big buyout from First Union Bank in 1998. They went and convinced other banks (where their friends landed executive jobs) that they had some special guru knowledge. I think that of all the banks they worked for, those banks today either have zero value (went bankrupt), or the stock is worth about what it was in 1987. In other words, for the past quarter century, these people made salaries and bonuses for themselves, but not the shareholders.
When cash pays zero, and when you don’t have lending opportunities, what you do is you shrink your bank. It’s the market telling you that, no matter how much of a guru or super-trader you think you are, your job really is not justified.
What you see going on, on Wall Street, and what was happening in Philadelphia in the 1990’s, is that high-paid people who produce nothing extra for the economy, are hunting for reasons and excuses for why they are so valuable. But they aren’t. If more people understood what a bank did, more people would feel this about them, too.