Watching It’s a Wonderful Life is a Christmas tradition in Stevenson Towers. It has many merits as a film not the least of which is its protagonist George Bailey’s pithy explanation during a run on the family Savings & Loan of how a bank works:
“You’re thinking of this place all wrong”, he told his excitable customers. “As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house, right next to yours. And in the Kennedy house. And in Mrs Macklin’s house, and a hundred others……now we can get through this thing alright, but we’ve got to stick together, we’ve got to have faith in each other.”
And there’s the problem. Banking is at its heart a massive leap of faith. When you hand your money over to a bank you do so knowing that on any given day it can’t repay you and all your fellow depositors. The system only works because we have faith in each other and believe that not everyone will need their cash at the same time. And sometimes, as at Silicon Valley Bank (SVB) two weeks ago, and Northern Rock 16 years back, that faith evaporates with catastrophic consequences.
Actually, this description of how a bank works understates the model’s fragility. The reality is that to be profitable a bank must stretch that trust to breaking point. Most operate with only a thin buffer between the value of the loans they have made and the deposits they have accepted. This cushion, of maybe only 5pc of the bank’s total assets can be wiped out by a modest decline in the value of its loan book, or a fall in the value of the assets, such as government bonds, that it holds. When depositors start to worry that this might happen, some of them quite understandably want to put their money somewhere safer, which worsens the arithmetic further…and fast. No wonder banks used to be housed in such solid and imposing buildings – the show of strength matters.
Most people prefer not to think too hard about these numbers
Just like they don’t want to acknowledge that when they buy a house with a 95pc mortgage it will only take a small wobble in the property market to wipe out their savings. When I bought my first flat in 1989 for £70,000, I got lucky. It was in an area that was on the up and I was able to sell it in 1993 for the same £70,000 in the face of a crumbling market. Many of my fellow first-time buyers in the late 1980s housing boom were not so fortunate.
None of this is new news. But it takes one of the banking shakeouts that seem to come along every 20 years or so to remind us of these and other unpalatable facts about banks that we’ve relearned in the past two weeks.
First, they are not like other businesses. They may look like risk-taking commercial enterprises, and their senior executives are certainly paid as if they are, but they are better viewed as regulated utilities that cannot be allowed to fail – no different from water and energy firms, roads and rail. The Swiss authorities reassured us this week that the rescue of Credit Suisse was a commercial solution and not a bailout but this is a myth. Neither UBS nor Credit Suisse had any choice in the matter, albeit the bank doing the takeover had some leverage when it came to the terms of the deal.
The way in which the deal was structured highlights another problem for investors in the sector, the unpredictability of its regulation when things go wrong. In the wake of the financial crisis a new tier of bonds was quite reasonably created in order to shift the balance of risk from the taxpayer to investors. Additional Tier, or AT1, bonds were designed to act as a safety valve, to absorb losses once equity investors had been wiped out and before more senior bondholders took a hit. The order in which the pain was to be taken was understood by all. Until this week that is. There may be good political reasons why the Swiss decided to rip up the rule book and leave money on the table for shareholders while taking out the AT1 bondholders completely, but the likely consequence of doing so is that the faith that George Bailey asked for will be harder to find in future.
We’ve learned some other things about banks this week that we haven’t room to go into: what bad investments they tend to be, subverting the usual rule that greater risk is rewarded with higher returns; that even good banks are vulnerable to the failings of bad ones when contagion gets a grip; that the whole banking system risks being rendered obsolete by new technology – fintech does it better and cheaper.
There are some broader lessons to be learned by investors too
Here are four:
First, beware of businesses that require leverage to make an acceptable return. Gearing works both ways. It ramps up profits in the good times but wipes them out in the bad.
Second, understand the risks you are taking with your investments and don’t invest in things you do not understand. At the very least, make sure that you mitigate the impact of investing in things you’re not sure about by investing broadly across many sectors, asset classes and geographies.
Third, be careful when investing in businesses whose future lies in the hands of politicians and regulators. They have a different agenda and the interests, or even property rights, of investors are not necessarily their top priority.
Finally, avoid wishful thinking. This may be a storm in a teacup. The problems at SVB and Credit Suisse may have been idiosyncratic and company specific rather than systemic. But I remember thinking and writing something similar in 2008. As George Bailey discovered, even a wonderful life has its dark days.
