This is an unedited draft for my banking manuscript project. It might be a good idea to incorporate some of this content into earlier articles discussing the self-financing nature of the banking system. Although I had planned to write a different article beforehand, I decided to add this discussion in response to some readers’ comments.
When I discuss the self-financing nature of the banking system, the risk is that my arguments suggest to some readers that a bank can make all the loans it wants without ever worrying about financing. I was aware of this risk of understanding when presenting my examples: I tried to highlight the practical limits of what the bank can do. However, readers might skip the numbers or simply see out-of-context quotes from what I write. Rather than bury everything I’ve previously written under a layer of waffle, I want to spread out the concerns here in a self-contained discussion.
Why self-financing is important
My discussion of self-financing takes aim at dubious attempts to resurrect loanable funds theory – the idea that the pre-existing pool of “savings” is fixed and all banks do is redirect the existing savings of “savers” » towards the “borrowers”. » We could remove banks from the economic model (or even from the real global economy) and nothing would change except the increased efforts by “savers” to find “borrowers.” The key point is that the amount of savings is fixed, and so we can use “supply and demand curves” to make statements about the effects on interest rates so that “the savings balance out.” To the extent that people try to argue that loanable funds is a reasonable theory, they should ignore the “savings are fixed” part of loanable funds and play word games to obscure the argument.
We need to track transactions: if a bank loses deposits due to capital outflows, this amounts to an injection of settlement balances into the rest of the financial system. These settlement balances must go somewheree — and this implies that the bank can theoretically draw on these balances in interbank or wholesale funding markets.
There is no guarantee that a bank will obtain these funds. However, in practice, major banks have treasury teams that will source the necessary funding (or place excess funds in other financial assets) every business day, year after year. While I imagine some small banks have failed due to incompetence, I don’t know of any large banks in the modern era that have suddenly failed solely because their treasury teams miscalculated. (The fact that central banks are the lender of last resort helps, of course.)
Fragmentation
It is possible to question my assumption that we view the banking sector from the perspective of large, modern banks, centered on money centers, which have full access to almost all national financing markets (and can even call to foreign financing via instruments such as currency swaps). Banks dominate activity in most developed financial systems. This is less true in the United States – the country of most of my readers (based on book sales data). And if we want to discuss historical experiences prior to the deregulation of the banking and financial sector (until 1990, depending on the country), traditional banks were less integrated with other financing markets.
If a bank is not fully integrated into all financing markets, the observation that the financial system is self-financing may not be entirely useful. Such a bank cannot blindly grant loans without concern for funding, because settlement balances could “leak” into markets it cannot tap into.
An artisanal bank
Let’s imagine that we are dealing with an artisanal bank whose financing is based solely on demand deposits, term deposits, equity (and in the worst case, discount loans). It is cut off from funding markets – so the self-funded nature of the system may not be helpful. It holds high quality money market assets, and possibly the liabilities of a “senior” bank.
Such a bank cannot hope to survive without having a significant buffer of liquidity – which means that it will have many more deposits than outstanding loans. Excess deposits end up in high-quality money markets. The entries and exits of the bank will correspond to the exits/entries of this market (or of the senior bank). The self-financing property of the system is manifested by the fact that if the bank needs to liquidate certain Treasury bills, it has injected into the system the funds that correspond to the liquidity needs of the entity purchasing the Treasury bonds. This is not very surprising: no one would expect that a small bank selling part of its Treasury portfolio would cause the Treasury market to seize up. (In any case, the central bank acts as de facto back stop of the ticket market.)
The need for a significant liquidity buffer is not contradictory to my previous examples. The example bank has a target liquidity ratio as well as a regulatory minimum – and both of these were my arbitrary choices because they made the numbers easier to track. (Since banks cannot completely control their inflows and outflows, they really need to have a liquidity ratio target band – which will be a band around a certain target level. I am simply referring to a “ target ratio” rather than a “target band” for simplicity) The principle that matters is that real banks must set a target liquidity ratio – and this ratio will depend on the situation of the bank. If the bank has no other sources of short-term funding, it has no choice but to wait for new deposits to expand its liquidity buffer. Large banks establish connections with wholesale funding markets for one reason: they can reduce their cash reserves (which have lower expected returns than other assets).
A traditional bank cannot hope to survive if it does not grant loans. Which means that it must expect capital outflows. What matters is that they need to replenish their liquidity – either by waiting for deposit inflows or by issuing financing instruments. If a bank decides to cut itself off from all financing instruments, it has no choice but to wait for new deposits to “walk through the front door” before increasing its lending again. However, the banks that decide to follow this strategy do not represent a significant part of the financial system of modern economies.
Over time, even less sophisticated banks may attempt to convert their demand deposits into term deposits to secure term funding. (Savings accounts can also help.) A large bank can issue bonds, but there is a minimum size for a viable bond issue: term deposits are only a retail-sized bond (with a little more flexibility).
Another possibility in the modern era is mortgage securitization. In the United States, the main agencies work with banks of all sizes. According to Freddie Mac, “these divisions work with lenders of all sizes – national, regional and community lenders and credit unions – to purchase conventional and conforming mortgages for one- to four-unit homes – including condominiums and prefabricated houses – up to a certain amount set by our regulator. (URL: https://www.freddiemac.com/about/business, quote taken 05/01/2024.) As long as the bank is large enough to be considered a “community lender”, the resources exist to enable the bank to remove mortgage loans from its balance sheet. And for a community bank, this, added to term deposits, could be enough to “strategically” manage the liquidity ratio: the liquidity portfolio would absorb short-term net flows.
History
One of the main problems with economists’ writings on banking is that they spend far too much time looking at historical banking systems, particularly in the United States. This is partly for ideological reasons: hard money enthusiasts want to portray the Gold Standard era as “normal.” For those of us who aren’t fixated on shiny rocks, this isn’t a problem. (As a disclaimer, I own shares in a Canadian gold mining fund at the time of writing, but I’m not sure why.)
The historical behavior of banks only matters if you have access to a time machine. The current operating procedures of major banks will be nothing like those of banks of previous eras.
There are two key differences. First, old-fashioned management would be considered horribly amateurish by modern standards. This certainly reflects the technological gap: the increase in the capabilities of digital computers allows for much more effective monitoring of a bank’s situation, as well as risk analysis. Second, many of the funding markets used by the big banks did not exist.
The situation in the United States was even more complex due to the fragmentation of the banking sector. Small banks in rural areas had very seasonal cash flows – due to farmers’ needs to finance the purchase of seeds and fertilizer, and then irregular cash flows as crops were harvested and sold. This has created significant seasonal net flows between different segments of the banking system. (In countries like Canada with a more centralized banking system, these seasonal flows would move between branches of the same bank.) Although some readers may find discussion of this era interesting, one must be very careful: it will offer almost no useful information for understanding the dynamics of a modern banking system.
It is absolutely no surprise that banks with treasury teams with less analytical support and very few liquidity management tools are quite conservative when it comes to cash management. However, this fails to understand the core of modern financial systems.
Concluding Remarks
Banking is a cyclical business. Banks make loans that result in draws on deposits, which are then offset by tapping funding markets (or the passage of time). Treasury teams are not worried about existing financing, but rather about the price of financing and whether it will be provided to them in particular.
Discussion of the self-financing nature of bank loans takes aim at loanable funds theories, which suggests that financing may not exist. anywhere if savers do not arrive first.
Email Subscription: Go to https://bondactivities.substack.com/ (c) Brian Romanchuk 2024
