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Broadly speaking, banks operate under the concept of maturity transformation. Banks take short-term – less than one year – financing vehicles, such as customer deposits, and use that to finance long-term – more than one year – returns. These returns range from the most commonly understood loans, such as auto loans and mortgages, to investments in equity, bonds and public debt. Banks make money on the interest spread between what they pay to the owners of the money and what is earned from the operations. Banks also make money on other services, such as wealth management and account fees, though these are relatively small compared to the maturity transformation business.

In terms of assets, the primary asset a bank holds is the demand deposit, also referred to as the core deposit. These are your everyday savings and checking accounts. Banks also sell Wholesale Deposits, such as CDs, have shareholder equity and also can take out debt, such as interbank lending. As these assets are owned by someone else, each of them demands a return for the use of those assets. These are part of the costs of operation for a bank. There are also more fixed operating costs, such as employees, buildings and equipment that must also be financed.

So, a bank will take assets and formulate loans on them. Like most of the world, the US operates on a fractional reserve system, one where banks originate loans in excess of the deposits on-hand. Take a look at the balance sheet of a large regional bank, 5/3 Bank, for example. For the 2018 fiscal year, 5/3 reported non-capital assets of $94 billion and a deposit base of $108 billion. However, the cash and cash equivalent component of these assets stood at $4.4 billion, or just 4% of demand deposits. It is critical, then, that the bank convinces those depositors to keep their deposits with 5/3 and not request a withdrawal. Doing so would collapse the bank as it's unable to quickly make good on any withdrawal request greater than 4% of the deposit base. To do this, the bank pays the depositor interest on the deposit.

How the Collapse Happens

This is where interest stability becomes a problem. When the Federal Reserve manipulates interest rates, banks are able to project fairly steady expenses for operations. While a business likes it when operational costs are relatively constant, this creates major problems for the banking system. When interest rates are suppressed to near 0% for, let’s say, a decade, the banking system builds up an income portfolio that is anchored to that near 0% cost of money. Back to the 5/3 balance sheet, we notice that the bank’s returns were $5.1 billion, or around a 5% average return on assets. $4 billion of those returns are tied up in $94 billion in long term lending. Interest expenses came in at $1 billion, or a little over 1%. The company also has $3.9 billion in relatively fixed operating expenses.

Basically, 5/3 Bank is operating on fairly thin profit margins relative to the bank’s asset base, which makes the bank highly vulnerable to any interest rate fluctuations.

Let’s say the Federal Reserve, then, begins to step up the target interest rate. As the Fed reduces competition on the market and sells assets, interest rates rise as these new assets begin to compete with existing assets. 5/3 then runs into a problem. If the risk-free rate starts to rise, depositors will look at that paltry deposit return and begin to wonder why they’re keeping money in the bank when other low risk vehicles are now offering higher returns. Since 5/3 can’t afford to lose much cash, the bank will be prompted to start raising deposit rates since they want to keep money in the bank. They will also have to refinance short term revolving debt at a higher rate.

The quandary to the bank is that nearly their entire revenue stream is made up of fixed-return vehicles. The effective spread between total costs and total revenue is just 0.2% of assets. This means that if financing costs increase by more than 20 basis points, 5/3 bank begins to take a loss. Since the bank had made loans for over a decade with these extremely low rates in mind, it will take some time to rebuild a portfolio of higher interest rate loans and investments to counterbalance this loss or the bank will seek to engage in high risk investments.

For a normal company, this isn’t a big deal. Companies can withstand losses for periods of time because they tend to build up a cash base to get through weak periods as they retool their operations. A bank, though, lacks this flexibility as they have to retain cash ratios to facilitate depositor withdrawals. A mere 1% increase in total borrowing costs to 5/3 will see the bank run out of cash in just four years, but since the bank has to maintain ratios, this will prompt the bank to begin selling assets to take on additional loans.

The problem compounds two-fold from this point for 5/3. First, the primary assets are income generating, so for every asset sold to keep cash ratios afloat just exacerbates the cash bleed and any new debt has interest expenses that need servicing, servicing without a corresponding asset return. Second, the assets have rates below market rate, so have to be sold at a discount.

Compounding further, every bank is operating like this. Every bank is operating on thin margins that assume a perpetual near-zero rate regime. If one bank has to unload assets to keep cash ratios intact, all the banks are inevitably doing the same. The largest portfolio item is usually the one that attempts liquidation – in 2007 that was the home mortgage. This selloff is self-reinforcing and creates a collapse since there aren’t many entities out there with free cash available to absorb this mass sell-off. Hence why the second largest asset class sitting in the Federal Reserve today is pre-2008 non-performing mortgage backed securities – the MBS holders, banks themselves, were stuck holding the bag. Banks ran to the last entity with cash available — the one that prints it — for a bailout.

Central banks will inevitably respond by trying to stabilize rates again, generally suppressing rates below the last cycle’s floor. Central banks, then, perpetually ratchet the rates down until they run into that 0% barrier then begin to engage in radical monetary policy when that lever is no longer available to pull. Canada’s pattern since 1980 is a perfect example of this, an ever downward sloping roller coaster.

How to Avoid This

If banks didn’t operate in a world of constant interest rates, an increase in rates wouldn’t be an especially large problem. First, if rates are fluctuating, banks naturally hedge against changes in interest rates. When they originate rates at a higher level and rates decline, they will enjoy a higher average return to build a buffer for when rates rise again. Second, if rates engage in natural fluctuation, banks would be hesitant to finance long-term loans using short term vehicles. Fractional reserve banking partially operates on the expectation that interest rates will remain stable for the long run. If the cost of money next month could be 20 basis points higher than it is this month, banks will have incentives to seek fixed financing solutions as opposed to leveraging depositor money. In other words, banks would likely cease engaging in maturity transformation since the risk of interest rates exceeding the return on the entire portfolio is just too high. That or at least limit exposure to this form of lending to something less than a gaudy 27-1 leverage ratio and promote sales of fixed financing like CDs. Market uncertainty and the removal of a central banking backstop would create a more stable banking system, which means naturally moving toward a full-reserve system.