4 October 2010

Banking Sector - Part II -  Deposit Insurance Schemes

Bloomberg today had an article that upto a third of banks in US could disappear (from 7830 today to 5000).  My initial reaction was that it was M&A related article, but as I read on I realised that it was related to the real bank windups.  Bank bankruptcies are on the rise, what should be no surprise to anyone.  Afterall the inflation is not growing fast enough to bailout every bank, and accrual accounting rules are not applicable to all the instruments.

In summary there are now 129 banks that went bankrupt in USA this year, most recently Wakula Bank from Crawfordsville, FL, and Shoreline Bank from Shoreline, WA.  The Federal Deposit Insurance Corporation stepped in and paid USD154.8m to cover the deposits of these two institutions alone.

For complete list of failed banks in US visit:

In addition the list of banks that are in "danger" has grown from 775 institutions last quarter to 829 institutions today (more than 10% of all banks), with the joint assets of these institutions today are USD403bn (what is still less than USD600bn assets of Lehman alone).  This brings me to the real topic of this commentary, that of the role of the Federal Deposit Insurance Company (FDIC).  

In general it is difficult to write something against common accepted standards, and in every at least developed country I know there is some form of deposit guarantee scheme, making it almost a given assumption of any banking model. 

However after a long analysis of this strange and complex public-private relationship, it becomes evident that apart from granting some sort of morale and illusion of confidence (that further comes with the implied government support), these Deposit Insurance Schemes make little sense.  For the the start it implicitly assumes that all the bank deposits have the same level of seniority, as ultimately they are all insured by the same entity.  This alone creates a significant moral hazard problem, as effectively banks are forced to compete on offering higher rate of returns - for ultimately the same level of risk of the depositor, which can be paid for by holding of the riskier assets.  It hence appears that the the presence of such guarantees promotes the banking model based on aggressive risk taking, risky assets, maximum of what the regulators will allow the bank to do.  More importantly it is NOT the banking model based on providing security to the depositors, stability of the investments, protection of principal (as all this is at the moment the function of the FDIC protection).

However politicians will argue, that someone must help the common people decide which bank is good and which bank is bad, as people are not qualified to do this - yet at the moment we are simply assuming that all the banks are good (in zero /one terms, and there is no room inbetween).  Another important political element is that politicians under no circumstances can afford for banks to fall, and people to lose their deposits.  This creates panic,and in some cases can almost lead to the revolt.  Very few will hence publicly speak out against the Deposit Scheme, as it is there to ensure stability to the system.

So what would  a Vision of the real efficient banking sector be like?  This is not the question with an easy answer, but in my view it would we should most likely start by dividing the banks balance sheets into the activity focused groups:

1) mortgage banks, where people save in order to one day have a prepayment for the mortgage... and where the money is used only for the mortgages... ideally with a reasonably locally focused target group.  Duration is managed, as is the security of the investments and indeed risk (at worst if the houses collapse say by 50%, its assets will also go down by say 50%, taking away equity almost halving deposits - but guess what - these deposits will be able to buy the same amount of property they could buy before.

Long time the mortgage savings accounts would exist.  People would often have it running for 15 - 20years, often with the accounts being setup by the parents.  These savings would at first be of course used for other mortgages, but at some point they would form a prepayment for the rest of the house.  It would be like a club.

2) industry banks, covering their employers (railway bank, miners bank, airlines bank), where basically services such as loans and credit card would be covered.  Credit card is a particularly difficult business for me to understand, as it appears to be a loan with the much higher rate and a nicer drawback method.  But afterall credit card business was created for a short, upto 1 month credit, which would be repaid from salary at the end of the month.   Similarly with the unsecured loans... if you have a job, you can have a small loan, secured by the cash flow from your employment.  And actually especially the credit card element makes sense... as even though you might be paid on the 30th, you have had hopefully already benefited the company with your produce, making their loan to you also their ideal cash management strategy

3)  local community banks, covering consumer loans aimed at specific purchases:   
historically even the consumer loans would always need a purpose:  some purchase of the car, or fridge, perhaps even a savings for the one a year holiday.  Community banks were best to handle such analysis, as they had the contacts and knowledge of the individuals.  People had small deposits, and like with mortgages they could use them to buy a fridge, or a new  tv.  Everyone however knew each other.  Indeed such strategy is very much behind the current Greenbanks Community Banks in India and other developing countries.

4) corporate banks that would deal with trade finance, bonds, corporate loans.  Historically This would be a more capitalist activity, with wider participation of the individuals and communities in countries like UK and USA, and a strong government sponsorship in the likes of South Korea, or many years ago Germany.

Now in conclusion what we are getting at is that while there is nothing wrong with the concept of universal bank, like the powerful branded institutions with top technology, management, efficiency, a reputation to be a money intermediary on many fronts - from corporates to mortgages, but I do think that it is urprising how can someone who is hoping to save for the mortgage be financing oil exports in Africa, using the same balance sheet.  It may hence be that rather than splitting the banks according to size, its better to divide their balance sheets according to their activities, what would be totally logical.  In doing such: JPMorgan Mortgage Bank would offer a much lower rate of deposit than say JPMorgan International Export Bank or JPMorgan Community Bank.  All the JPMs would be under one roof (one brand, one network), but at least people would understand what their money is used for, and if needed accept the consequences of their decisions.