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Banking’s Unique Business Model, And Why Capital is not a “Rainy Day Fund”

Banks are highly regulated businesses, as expected of entities to which we entrust our money, and from which we may expect to borrow someday to buy a home or start a business. 

Bankers interact with regulators daily. Investors wishing to establish a bank must first obtain capital pledges from future shareowners and apply for a bank charter from either federal or state government regulators. 

Once in business, a bank is overseen by one or more of the following state and federal regulators: a state banking commission if a state-chartered bank, Office of the Controller of the Currency if federally-chartered, the Federal Reserve if a member of that system and/or a one-bank holding company, National Credit Union Administration (NCUA) if a credit union, Federal Deposit Insurance Corporation (FDIC). the Consumer Financial Protection Bureau (CFPB), Securities and Exchange Commission (SEC), and Federal Financial Institutions Examination Council.

While this regulatory structure may impose excessive intervention into the private economy, and undoubtedly creates some redundancy, the unique nature of banking suggests that bank regulation, at least in some form, is justified, given banks operate on fractional reserves.

The Unique Feature of the Bank Business Model

Banking is unique in its dependence on “leveraging,” that is, using someone else's money to make a profit for oneself. Banking is also unique in its role as middleman between bank depositors and bank borrowers, using depositors' funds to lend to loan customers. Use of depositors' funds, moreover, is often short-term since owners of bank accounts can withdraw their funds on demand, whereas loans to borrowers are typically long-term, such as 30-year mortgages. All these unique features of banking can make it an inherently risky business, as history has shown.

Banks are profitable when they pay depositors one rate of interest, then charge borrowers a higher rate of interest. As an adage goes, bankers live by the 5-4-3 rule: charge borrowers five percent, pay depositors four percent, and be on the golf course by three o'clock.

Many other businesses, some quite capital-intensive, are non-leveraged. For example, a manufacturer operating an assembly line with heavy machinery is not a middleman as a bank is, and no leveraged borrowing-lending occurs as in banking. Most service businesses operate similarly, though without capital-intensive real property. These non-leveraged businesses do not require the capital regulatory oversight that banking does.

Capital Requirements Justified for Leveraged Businesses

It is in banks' nature, as leveraged businesses, to be under-capitalized because capital ties up funds that are not available to make loans or cover operating expenses. Bank capital should be considered a permanent cushion to absorb losses among one or more bank assets, such as defaulted loans or mark-to-market declines in a bank's securities portfolio.

A bank's capital account consists of funds invested by original shareholders, augmented by retained earnings over a bank's life. Capital is normally invested in safe US Treasury bonds and is not available to make loans or cover operating expenses. It is neither an asset nor a liability on a bank's balance sheet. Rather, it is a separately sequestered entry on the right-hand (liability) side of a bank's balance sheet. Capital can be calculated as the difference between bank assets and bank liabilities. With proper bank management, this difference is positive; if negative, a bank would be considered insolvent.

Capital requirements are expressed as capital-to-asset ratios, on which bank regulators keep a close eye. Ratios typically range from 6-10 percent, depending on the deemed riskiness of a bank's assets. Any shortfall in a bank's capital: asset ratio is serious cause for concern, and must be corrected as soon as possible, perhaps even with an offering of additional bank stock to existing or new shareholders.

A Note About Bank Reserves and Vault Cash

“Capital” and “reserves” are often easily confused, so it's important to use the terms correctly. Many financial journalists who should know better sometimes interchange “capital” and “reserves,” even sloppily referring to either or both as “cash.” Recently a New York Times financial writer admitted that he misrepresented bank capital for many years, likening it to a “rainy day fund.”

Bank “reserves,” a term with very specific meaning, are calculated as a percentage (normally 10 percent or less) of deposit liabilities. If a bank holds $1 million in deposits, for example, it is required to retain $100,000 (10 percent) in reserves, funds in the form of vault cash and/or reserves in its own account at its local Federal Reserve district bank. both of which are considered assets to the bank. The remaining $900,000 is available to create new bank loans to bank customers.

A bank unable to meet its reserve requirement can always borrow spare reserves (called “federal funds”) from other banks that have excess reserves, or in a pinch apply to the Federal Reserve for a short-term loan. Failure to hold minimum required reserves is considered a no-no in the banking world, and options exist to obtain additional reserves if necessary.

“Cash” is another banking term that must be used correctly. While not monitored by regulatory agencies, banks maintain vault cash (Federal Reserve Notes and Treasury coin) to satisfy customers' demands for withdrawals at the teller window or ATM. Maintaining cash is an expense for banks because it earns no interest and must be stored in secure vaults. Banks absorb these expenses but would be justified in charging customers to cover the cost of handling cash (and indeed, some banks do charge for withdrawals through ATMs). 

While capital is considered a sign of a bank's financial health, neither bank reserves nor vault cash in any way provide any such indicator.

Recent Calls for Higher Bank Capital Requirements

Following last year's liquidity problems among Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank, many regulatory agencies and politicians (but I repeat myself) have called for higher bank capital requirements. It is clear, however, that insufficient capital was not a major cause of these banks' difficulties

SVB, for example, experienced an internet-era bank run in which depositors (some of whose accounts exceeded the FDIC's insurance limits per account) suddenly requested large withdrawals on-line.

Unable to draw on assets that would traditionally supply funds for withdrawals — vault cash, portfolio assets such as short-term investments, or the Federal Reserve's lending facility – the FDIC and US Treasury Department stepped in to honor SVB depositors' balances above the regular insurance of $250,000 per account. The culprit here was SVB's portfolio containing Treasury securities whose market value had declined when the Federal Reserve began raising interest rates in 2022, causing mark-to-market security prices to decline below SVB's cost basis in those assets

Later analysis of SVB's problems revealed that it was not undercapitalized, and that its capital: asset ratio was 10.4 percent, well above its seven percent regulatory requirement. And if it had included unrealized losses on its security portfolio in calculating its regulatory capital, its capital: asset ratio would have been even higher, performing well in the Federal Reserve's bank stress test.

SVB's major problem was not insufficient capital, but rather its inability to raise cash by selling the securities in its portfolio without taking large investment losses. As the Federal Reserve's report on SVB's and Signature Bank's downfall concluded, “...its leadership failed to manage basic interest rate and liquidity risk....and Federal Reserve supervisors failed to take forceful enough action....” The report further cited SVB’s. “...rapid, unrestrained growth.... growth through an over-reliance on uninsured deposits..., and failure to understand the risk of its association with the crypto industry.” Capital was not cited as a factor in these banks' failure.

Concluding Thoughts on the Bank Business Model and Capital

Ideally, well-managed banks (and their depositors) should be free to determine the level of capital appropriate to the bank business model, but the industry's uniqueness has attracted regulators to enforce capital requirements. In the years following the creation of the FDIC in 1933, banks and depositors alike have become indifferent to the significance of bank capital because the FDIC covers deposit losses to a known limit---and in some cases beyond that limit, as in the SVB case.

The existence of this generous insurance coverage is an example of what economists call “moral hazard,” when economic actors (banks and their depositors in this case) are incentivized to incur more risk because they do not bear the full costs of that risk. In the FDIC bail-out of SVB's depositors, a major cost is borne by all other banks (and their depositors), who directly or indirectly pay deposit insurance premiums, thus socializing what should have been a private cost for SVB's management to handle. 

A final speculative observation is that the 2023 bank failures may reflect the state of fear that beset the US during the 2020-23 pandemic that is now finally beginning to dissipate as Americans return to relative normality. Bank regulatory agencies, calling on the FDIC for extended coverage of deposit losses and then recommending higher capital requirements for the affected banks, may have overreacted to the initial failure of SVB, fearing widespread virus-like contagion throughout the banking industry. Some have speculated that Covid lockdown measures were a dress rehearsal for something even more divisive and destructive; perhaps future historians will begin successfully to analyze and describe the extensive side effects and aftereffects of this era.

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