Building the new order Entry 5

There has been an attack on the Nova Kakhovka dam in Ukraine. The flood damages are very large, affecting the population, the economy, the ecology, future crops, and the protection of the nuclear power plant (news here).

Military operations are also affected. It will not be easy to continue the attacks in the affected areas.

The authorship is disputed. Everyone says it was the other one. It seems to me that the truth will not be known for a long time. It may even have been someone who was not a combatant in the war, but who wants to force a borderline situation in order to seek peace negotiations. I compare it to what happened in the Nord Stream pipeline.

Michael Klare signs an important article in FPIF (I remember that it is a very influential media in the left woke USA). It can be seen here. He comes to say that the USA has to recognize that the Ukrainian War can only be solved with the support of China. That neither Russia nor Ukraine will win. And that, in later times, the USA will cease to be the only world power and will have to share it with China and India through something they call the G3. It is something obvious, as we have seen in these entries, but it is being said by the ideologues of the American Democratic Party, which is still governing, which is the novelty for me.

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More about banks.

At previous entry I outlined the characteristics of the current situation of the banks. In this one I will try to look at the ways in which the system can fail, and what can happen in the aftermath.

Possible system failures.

In view of the above, there are two main ways in which the whole system associated with bank stability can fail.

Both are based on the same underlying concept, which is that banks do not manage their own money, but that of the users.

The first is whether the user is afraid that his money is well guarded in the bank. If that happens en masse, the bank fails in the face of deposit withdrawals, as we will see below in the recent example of the SVB.

The other, more long term, is when users find better service for their interests in other entities. In that case, they also withdraw their money and take it to those entities. This has the consequence of transferring the current power of banks to these entities, as may be happening now in the shift to the technological ones after examples such as Apple’s recent offer to open current accounts there with yields ten times higher than those given by banks (news here).

The problem of the short term.

As we have seen with the working capital (in the previous entry), almost by definition banks are companies doomed to imminent bankruptcy if depositors withdraw their funds on a massive scale. This is what has happened with the recent bankruptcies.

And why would depositors withdraw their funds from the bank? Well, for fear of losing them in the event of the bank’s failure.

And why should depositors be afraid? Because they know that, if the bank fails, and their funds are not guaranteed, they will lose them (I will talk about the guarantees of the funds later).

Until recently, most depositors (out of ignorance) thought that their funds in the bank were protected.

Today, after the communications revolution and social networks, they can find out about risks very quickly (within hours). And the same technologies allow them to give their transfer orders to other banks in hours (or minutes), which is very different from what happened before, when it was necessary to physically go to the bank, and the bank had time to ask the government for help to decree a “corralito”.

Bankruptcy due to withdrawal of deposits.

We have seen in the previous entry that balance sheets must be balanced. Therefore, if a bank suffers massive withdrawals of deposits (which are the bank’s liabilities), it is forced to balance the balance sheet. It can do so:

With a capital increase. But it would be a very large capital increase, which the current shareholders would not be able to contribute, nor would they accept to be diluted by a potential new shareholder (who would not want to invest a lot of money in a place that is almost bankrupt).

With a greater attraction of liabilities (money from the owners of current accounts, or credits from someone), which does not seem easy in this situation of near bankruptcy, when deposits are “going, not coming”.

They may also try to raise other types of liabilities, such as loans from other banks, or from central banks. By doing this, they can buy some time, but, as they are expected to continue to generate no profit to pay back those loans, the likely end result is that they will be forced to merge with other banks (the creditors), or be nationalized.

Or, with asset sales.

Those assets that it has to sell are the banks’ investments, which may be unmatured loans granted, government or corporate bonds, or shares of companies owned by the bank.

Of course, before making these sales, the bank will pay for the asset withdrawals with whatever liquidity it has in cash, but, if the withdrawal is massive, it will not have sufficient liquidity, and will have to sell assets.

It so happens that, in the current situation of rising interest rates, the loans the bank has granted and the bonds it has purchased are from previous years, when rates were lower.

If the bank is forced to sell these “receivables”, the buyers have to choose between buying what the bank offers them (e.g. old bonds at a very low interest rate), or what they can buy in the market (e.g. newly issued bonds at a much higher interest rate). In that case, the buyers of what the bank needs to sell will only buy it if it is sold to them at a discounted price, which must imply higher profits than the option of buying new bonds.

This means that the bank has to sell its assets at a lower value than it has on its balance sheet. In other words, it has to take losses. And, if these losses are significant compared to the bank’s equity, it may find itself in a situation of bankruptcy.

The example of the SVB.

As they explain well here, SVB (Silicon Valley Bank) had unrecorded losses of $15.162 billion. Those losses would be the result of having to sell its assets at market prices after the interest rate hikes. As also stated in that news item, SVB’s shareholders’ equity was $16,295 MM, which put it nearly bankrupt.

On the other hand, the same news item shows that SVB’s balance sheet total was $212 billion, which means that shareholders’ equity (shareholders’ money) was approximately 7.7% of the balance sheet total (money managed by the bank). And unabsorbed losses were 7.3% of the balance sheet total.

To compare with other situations, Banco Santander, in September 2022, had equity of 16.18% of its balance sheet total (as can be seen here), which is much higher than that of SVB. If the undeclared losses were in the same range, which would be logical, because its investments in loans and bonds are also made in times of near-zero interest rates, it would not be in a position of bankruptcy, but it would not be very comfortable either.

As a continuation of the SVB problem, there is a lot of talk in the USA about which other banks may be next. There is data here, and here. There is also fear in Europe (news here, where they also highlight the problems of banks to adapt to technological changes).

Speed management. Derivatives.

As we have seen above, the basic problem of banks in the short term is that their assets (loans granted, bonds purchased, shares owned, …) were acquired before this crisis, when interest rates were low. This means that the profitability of these assets is low.

However, their liabilities, which is the money deposited by their clients, are asking for their profitability to be increased (after the rise in interest rates). More or less, they say: “if you don’t raise our profitability, we’ll go elsewhere”.

The bottom line is a matter of “mathematical derivatives”. Of speed of change.

As interest rates rise, banks find that their investments (loans granted and bonds purchased) have fallen in value due to the need to sell them. And, with their money collection (current accounts) asking for higher profitability.

But, let’s remember that the bank raises funds in the short term and invests them in the long term. And that its profit is in the price difference between both operations.

If it happens that you have to start paying more interest to current account holders to keep them from leaving, that means that your costs go up. And they go up immediately (or the current account holders leave, which is not in your interest at all).

However, its income comes from contracts signed long ago, and for a long term (loans granted or bonds purchased). And you cannot quickly change the interest rates of these contracts.

Therefore, if your costs go up, but you cannot raise revenues at the same rate, you are at risk of losses.

That is the problem today: the speed of change. And it affects any bank, although, of course, some are better prepared than others.

The general tactic is to try to convince depositors not to leave yet, because they are a safe place (the confidence speech), and to promise them that they will increase their remuneration, but as late as possible (news here). As well as doing so at the same time as they try to sell their old investments (credits and bonds), which were at low yields, to replace them with new investments (also credits and bonds, but at higher yields).

And this tactic has to be done by managing the speeds (the derivatives) at which they change fundraising and investments.

At present time, no matter how fast they do things, the issue leads them to take losses. They will be the result of selling old investments at a low price.

Of course, if they manage to do it before the costs are increased (remunerating current accounts), and if they do it slowly enough so that these losses do not lead the bank to bankruptcy, they can hold on. You can see figures of this process in this news item, where they also say that public debt is “zero risk”, which I do not agree with at all; and in this other news item, where it is clear the process of substitution of bank investments, reducing those destined to credit, which helps to control M2 a little.

What is certain is that, at some point in the future, interest rates will fall. At that point, the trend will be reversed. Banks will not be under pressure from depositors to raise their remuneration, and their investments will be made at the high (now falling) interest rates.

The big question is whether they can make it “alive” to that moment.

Making very big numbers, if banks have own funds in the order of 10 to 15 % of their balance sheet (which are already high compared to the usual); and if they have to assume losses in their total investments of a minimum of 3 % per year; this leads us to think that they can last three or four years, if they manage the speeds well, before they go bankrupt because they consume all their own funds. They need interest rates to change downward before that time is up (which is likely, but not certain).

If they do not manage those speeds well, or if interest rates do not change in three years, the other alternative they have is to seek a very significant capital increase (almost doubling their current capital). But few people are going to want to buy shares in a company in that situation, and few of the current owners of the bank are going to accept losing their share of power in it. In other words, this capital increase does not look easy.

This whole speed management issue is explained very well by Ray Dalio here.

It is because of all of the above that banks are trying to pressure central banks to reduce rate hikes, or to start lowering rates. The central banks are replying that they cannot do so because inflation is not yet responding. And the commercial banks are trying to say that they are already helping to correct inflation by restricting credit, and creating less M2.

It is to be expected that the tension over bank stability will continue until interest rate cuts begin. Perhaps one more bank will fall, in which case, the solution will be for it to be absorbed by another more stable bank with the support of the central bank, as long as that central bank still has strength left. If it runs out of strength, we will be in the long term problem, which I develop below.

FGD – 100,000 €. Not enough.

In each country there are different rules to guarantee depositors their money in the event of bank failure.

In Spain, the institution is called Fondo de Garantía de Depósitos (FGD), and in theory it guarantees up to 100,000 € to each current account owner (in the USA it guarantees up to 250,000 $). Above these amounts, if the bank fails, the depositor loses his money.

But theories and rights written in a law are one thing, and the actual ability to pay is quite another.

The fact is that the Spanish FGD has, as of 2021, 4,421 MM € (data here). And, according to its balance sheet for 2022 (see here), Santander bank alone has customer deposits of 966,353 MM €. That means that, if only 1% of the current accounts of Santander depositors were less than 100,000 €, even so, the FGD would not have enough money to pay them. Much less if several banks fail at the same time.

That is to say, it seems that the guarantee of the FGD is very nice in written law, but very unreliable to actually collect if the case arises. The FGD may work well in the case of a small and punctual bankruptcy, but not in the case of something large and generalized.

The problem of the long term.

I have already advanced it above, but I explain it more fully here. Even if the important short-term problems of the banks are resolved in a more or less appropriate way, the long-term problem will persist.

The problem is that, after the technological revolution, today’s banks are not well prepared to provide the service that society requires.

The underlying idea of the banks’ sense of being is that they were able to gain the confidence of those who had money (and didn’t know what to do with it), while at the same time being able to identify those who had good ideas and needed money to implement them. They did this, in the times that are coming to an end, with the knowledge of people that the old branch managers had.

That capability was based on having a strong knowledge of the customer profile, and the ability to build customer loyalty and support.

Today, bank branch networks are disappearing. And, managers’ knowledge of customers is at an all-time low (as is customers’ trust in them, when in the old days a branch manager knew more about his customers than his confessor).

At the bank’s head office, they think that they have “gone digital” and that they know the profile of their customers through their digital tools. And that they can make their decisions with that information.

However, banks are not aware that their ability to know the profile of customers by those “digital analytics” is far behind the capacity that technology companies have today (those who know how to send us the timely announcement of what we are saying just now, which is a matter that is much talked about for fear of being “heard”, but has much more to do with them “knowing” us).

The truth is that, today, technology companies can provide, much better than the old banks, the service of crossing the needs of those who have money and do not know what to do with it, with the needs of those who do not have it and do know what to do with it, as well as being a reliable person.

Therefore, I think that, in the long term, banks will be replaced by technology companies. This could be by buying them out (before or after their bankruptcy), or by the simpler way of replacing them and taking their business (without having to assume their debts and inefficient structures).

However, it remains to be seen at what speed this replacement of “banking service operators” will take place. This will be greatly influenced by the need of governments to prevent the system from collapsing, as well as by the need to be able to manage the issues of controlling M2 (the creation of bank money), and the negative working capital of the banks, as well as the control of the banks with very little money from their main shareholders.

The truth is that, with respect to the issues of economic capacity, solving the short-term capital problems of the banks (which I have mentioned above) is child’s play for the technology companies. For example, we can see that Apple’s profits in 2022 were 99,000 MM $ (which is “new money” for them), and Banco Santander’s equity is 124,000 MM €, which may seem of similar magnitude, but in the case of the bank it is all the shareholders’ money “to defend” (rather to lose), and in the case of Apple I have already said that it was “this year’s new money” to decide what to do with it. That is, they are in different leagues. Only with the profits of one year, Apple can buy almost all the capital of one of the big banks.

Readings that have interested me.

For anyone interested in going deeper into the issue of banks, there is a good (long) study of the European financial system by pwc that can be viewed here.

At next entry I will address the issue of demographics, unless something makes me change my mind, …

As always, I welcome comments on my email: pgonzalez@ie3.org