Why banks are different

A previous post explored the question of whether banks are just like other companies or somehow unique. The post listed three distinctive features I believe make banks different and perhaps “special”:

• The way in which net new lending by banks can create new bank deposits which in turn are treated as a form of money in the financial system (i.e. one of the unique things banks do is create a form of money);
• The reality that a large bank cannot be allowed to fail in the conventional way (i.e. bankruptcy followed by reorganisation or liquidation) that other companies and even countries can (and frequently do); and
• The extent to which bank losses seem to follow a power law distribution and what this means for measuring the expected loss of a bank across the credit cycle.

This post will focus on the first two features which I think are related. As a rule, I am a fan of the principle of “strong views, lightly held”. I feel pretty strongly that my arguments for why banks are different are robust but acknowledge that there are contrary views on the question. My earlier post used a paper by Anat Admati and Martin Hellwig (frequently cited as authorities on the issues of bank capital discussed in this post) “The Parade of the Bankers’ New Clothes Continues: 31 Flawed Claims Debunked” as an example of the alternative perspective.

It is up to the reader to determine the validity of my rebuttal of Admati and Hellwig’s arguments but I recently read an interesting paper by Joseph Sommer that I think supports the position I was making for why banks are different. Sommer wrote the paper, titled “ Why Bail-In? And How!”, while working as an assistant vice president and counsel at the Federal Reserve Bank of New York. Central to his analysis is the concept of “financial liabilities”

Financial Liabilities

Sommer argues that one of the features that distinguishes a bank is that they create a special type of liability which he labels “financial liabilities”. He defines a financial liability as one whose value is impaired by the insolvency process. That may sound like a statement of the obvious. Insolvency naturally threatens the value of liabilities via shortfalls in the liquidation value of assets but Sommer is making a different point. He is talking about something more than credit risk impairing the value of these liabilities.

The reason is that “financial liabilities” are also distinguished by the extent to which the function of the financial instrument is to provide liquidity or shift risk; i.e. by the extent to which the liability is a “product” not just a form of finance. Bankruptcy disrupts the ability of these financial liabilities to perform these economic functions.

The customers who own these financial liabilities have a creditor relationship with the bank, just like other liability holders do. However, they do not buy these instruments as “investments”, they are customers buying a product.

“The creditor in such contracts is not primarily an investor: paying money now to get more later. Instead, it wants liquidity, or insurance, or other kind of risk shifting”

Insolvency destroys the value of financial liabilities

“The central policy implication of this article is that Financial liabilities deserve priority treatment in insolvency law but the standard bankruptcy process cannot do this.”

The bankruptcy process seeks to protect the value of the business by protecting the value of business assets. To protect the value of business assets, the process will typically seek to temporarily suspend the rights of liability holders to be repaid.

For non-financial companies, the value of business liabilities in the bankruptcy process is defined by their contractual claim (e.g. the promised payment of principal and interest) and their priority in the loss hierarchy. In theory, that value is not impacted beyond any shortfall in assets versus the priority of the claim the liability has, and the time value of delayed payment.

However, the value of a bank is also embedded in its financial liabilities not just its assets. Consequently, suspending the rights of these financial liabilities impairs the value of the liability in ways that harm the business.

“This notion of a financial liability as a product has implications for insolvency law, apart from priorities. Insolvency law assumes that firms often need a breathing spell from their creditors, so that they can pick themselves up, continue operating, and start reorganizing. It therefore places all claims in a collective procedure and places a moratorium on efforts to collect assets. However, financial products are operations of the financial firm. Freezing performance on a financial product, whether by automatic stay or treatment as a claim, is akin to prohibiting a carmaker in Chapter 11 from making and selling cars, or an airline from selling tickets, buying jet fuel, and flying planes”

Adapting to the challenges of the bank balance sheet

Ideally, insolvency law would preserve the liquidity or risk shifting functions of financial liabilities but the standard bankruptcy process is not designed to deal with this feature of the bank balance sheet. Sommer favours bail-in as a way to overcome the problems of applying the traditional insolvency process to a bank balance sheet. An alternative is to simply require banks to be capitalised with a much higher level of common equity.

Higher common equity is the solution advocated by Admati and Hellwig and most recently by the RBNZ.  I side with Sommer on this question, favouring a combination of:

• common equity calibrated to make a sound, well managed, well supervised bank Unquestionably Strong,
• supplemented with sufficient additional loss absorbing “capital” calibrated to what would be required if the bank were high risk, poorly managed and possibly poorly supervised

The distinction I am drawing between the capital requirements of “good” and “bad” banks might be dismissed as splitting hairs but it strikes me as a frequent source of confusion in the debate about how much capital and what type. Good banks don’t actually seem to need much capital whereas bad banks need a lot. Obviously, we don’t know ex ante which banks are good and which are bad. We do know that common equity is the foundation of any capital structure and we could just capitalise all banks with common equity on the basis that they might be bad banks. While not expressed so bluntly, this I think is effectively the solution recently proposed by the RBNZ.

Which solution is better lies outside the scope of this post. I have touched on this question previously in a few posts (see here, here, here, and here) but am yet to bring my thoughts together in one place. The main purpose in this post was simply to introduce readers to an interesting paper that I think adds some useful insights to the question of what makes banks different from non-financial companies.

Conclusion

There are various ways to make the argument that banks are different to non-financial firms. My earlier post highlighted the way in which net new lending by banks can create new bank deposits which in turn are treated as a form of money in the financial system (i.e. one of the unique things banks do is create a form of money). This in turn helps explain why bank supervisors are reluctant to allow large banks to fail in the conventional way that other companies and even countries can (and frequently do).

The argument I developed in the earlier post is a subset of a broader theme in Sommer’s paper. I focussed on the need to protect the value of deposits if they are to function as money. Deposits in Sommer’s argument are part of a broader class of what he labels “financial liabilities”. The conclusion however is the same, bankruptcy can protect the value of non-financial firms but it almost certainly destroys value in banks by impairing the value of financial liabilities. It is not the optimal solution for dealing with a failing bank.

It is also worth reading a paper by Gary Gorton and George Pannacchi titled “Financial Intermediaries and Liquidity Creation” which offers another angle on these issues. They note that credit intermediation between savers and borrowers has traditionally been identified as the key economic role of banks. Banks clearly do intermediation, but they argue that the really critical function of banks is to provide a liquid asset in the form of bank deposits that serve as a form of money (arguably the primary form of money).

The problem is that the capacity of a bank deposit to function as money depends on the ability of uninformed agents to use it without fear of loss; i.e. the extent to which the value of the instrument is insulated from any adverse information about the counterparty (aka bank). There are a variety of ways to make bank deposits liquid in the sense that Gorton/Pennacchi define it (i.e. insensitive to adverse information about the bank) but they argue for solutions where depositors have a sufficiently deep and senior claim on the banks assets that any volatility in their value is of no concern to them. This earlier post offers more detail on Gorton and Pennacchi’s paper.

I intend to try and consolidate these thoughts in a future post that will set out my take on the case for bail-in. In the interim, I can recommend the two papers referenced in this post to anyone seeking to understand bank balance sheets.

Tony