The Secret Diary of a Bank Analyst …

… is the title of a post that Marc Rubinstein dropped this week summarising his perspective on why banks don’t behave like other companies. This is a question I have long been pursuing and I found Marc’s post well worth reading. Marc lists the following factors:

  1. Customer or Creditor
  2. Public or Private
  3. Growth is … not good
  4. Confidence is king
  5. Nobody knows anything

Let’s start with a quick outline of Marc’s observations about why banks don’t behave like other companies.

1) Customer or Creditor?

Marc writes …

“The first thing to understand about banks is that they operate a unique financial structure. Other companies borrow from one group of stakeholders and provide services to another. For banks, these stakeholders are one and the same: their creditors are their customers.”

This is oversimplifying a bit. Banks do also borrow from the bond markets but the key point is that deposits do typically from a large part of a bank’s liability stack and depositors clearly have a customer relationship. Understanding this is fundamental to understanding the business of banking.

2) Public or Private

Marc writes …

“Banks have a licence to create money which confers on them a special status somewhere between private enterprise and public entity. Economists argue that commercial banks create money by making new loans. When a bank makes a loan, it credits the borrower’s bank account with a deposit the size of the loan. At that moment, new money is created.”

He notes that the privilege of creating money comes at the price of being heavily regulated. Getting a banking licence is not easy and once granted banks must comply with a range of capital and liquidity requirements tied to the riskiness of their assets and liabilities. They are also subject to intense oversight of what they do and how they do it.

All of that is pretty well known but Marc makes another observation that may not be so widely understood but is possibly more important because of the uncertainty it injects into the business of banking

“All of this lies in the normal course of business for a bank. What is sometimes overlooked, because it is utilised so infrequently, is the executive power that authorities retain over banks. In some countries, where state owned banks dominate the market, intervention is explicit … But even when a bank is notionally private, the state can exercise direct influence over its operations.”

3) Growth is … not good

Marc writes …

“Most companies thrive on growth. “If you’re not growing, you’re dying,” they say. For investors, growth is a key input in the valuation process. 

But if your job is to create money, growth is not all that hard. And if the cost of generating growth is deferred, because the blowback from mispricing credit isn’t apparent until further down the line, it makes growth even easier to manufacture.”

This certainly resonates with my experience of banking. If you are growing faster than the system as a whole (or aspire to) then you should be asking yourself some hard questions about how you are going to achieve this. Are you really providing superior service or product or are you growing by giving up one or both of margin and credit quality. At the very least, it is important to recognise that growth is often achieved at the expense of Net Interest Margin (NIM) and everyone agrees that a declining NIM is a very big negative for bank valuations.

Marc goes on to observe that …

“The corollary to this is that., unlike in other industries, competition is not necessarily that good either – or at least it comes with a trade-off against financial stability”

Some economists might struggle with this but bank supervisors as a rule can be relied on to chose stability over competition. Marc notes however that US are a possible exception to the general rule …

US authorities are unusually squeamish about the trade-off. Partly, it reflects a respect for private markets but mostly it’s because their smaller banks harness significant lobbying power. …

The US is not necessarily making the wrong choice – its economy is more complex than others and its companies have more diverse financing needs. But it is a choice. As Thomas Sowell said, “There are no solutions. There are only trade-offs.”

4) Confidence is king

The fact that banking is a confidence game is of course no great secret. Marc notes that the problem in part is that confidence in the bank is largely based on proxies for soundness (e.g. capital and liquidity ratios, supervisory oversight, credit ratings) that have a history of being found wanting. So the foundations of confidence in your bank or the banking system as a whole are not themselves entirely reliable. A bank can tick all the boxes but still lose the confidence of the markets and find its viability subject to the (inherently risk averse) judgments of its supervisor and/or central bank.

The problem is exacerbated by the fact that it is difficult if not impossible to restore confidence once it is questioned. Marc restates Bagehot’s classic take on this question …

“If you have to prove you are worthy of credit, your credit is already gone”

Lombard Street: A Description of the Money Market; Walter Bagehot 1873

as follows …

It’s very difficult to restore confidence once it’s gone. One thing not to do is put out a press release saying your liquidity is strong. You’d think people would have learned after Bear Stearns, but no. When the proxies cease to work, saying it ain’t so won’t help either. 

5) Nobody knows anything

Marc writes …

“The dirty secret among bank analysis is that it’s quite hard for an outsider to discern what’s going on inside a bank… It’s only after the the fact it becomes apparent what questions to ask.”

This is probably my personal favourite because I was a bank insider for close to four decades and now I am looking at banks from the outside (hence the name of my blog). I like to think that I learned a bit about banking over that time but mostly what I learned was that banks are really complex beasts and I am still learning new things now. Hats off to anyone who really understands banking without having had the benefit of working on the inside or having the access to talk to people working on the front line of banking.

So what

Marc’s observations accord with my experience so I recommend his post for anyone interested in banking. Banks are one of the core institutions of our economy and our society so understanding them is I think important. Even if you don’t agree with him (and me), his post offers a useful reference point for checking your perspective.

If you want to dig further then there are couple of posts on my blog (see links below) that dig into these questions based in part on my experience but also summarising useful papers and other insights I have come across in the as yet incomplete quest to understand how banks do and should operate.

Tony – From the Outside


Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: