How (not) to run a bank

Opinion Analysis by Sandro Joseph Azzam, Contributor

April 14th, 2020

In light of the Lebanese uprisings, Lebanese banks have taken it upon themselves to try and solve a crisis that they caused. The result has been a crisis even worse than the first.

The alleged stem of the crisis was the bankruptcy and bail out of 2 Lebanese Alpha Banks. The central bank (BDL) bailed them out, in accordance with its role of lender of last resort and the Money and Credit law of 1964. Setting aside the fact that the mere possibility of being bailed out creates infinite moral hazard problems, why did banks need to be bailed out in the first place? What was the trigger that moved us away from “business as usual” into what is seemingly a disaster?

To answer that, we should try and understand bank dynamics, how they make money but also how they lose it and who bears the burden of this loss. 

Depositor A comes to the bank and deposits 100$ to earn an interest of 3%. The bank takes part of these 100$ and deposits them at the central bank as part of their required reserves. These reserves are mandated by the nation’s monetary policy. Say the reserve ratio is 10% of the 100$ initially put down. With the remaining 90$, the bank now has to try and make money for themselves. They take some of the 90$ left and loan it out at 6% essentially profiting off the spread with interest paid on deposits. They also purchase government bonds, sell you a mortgage or buy securities. 

Basic banking practice, the opposite of which reigns in Lebanon, dictates that banks should keep a certain portion of deposits as liquid assets in case depositors want to withdraw money, a so-called liquidity buffer. 

If a bank has all of its money loaned out, what happens if someone wants to withdraw money? We must rely on there being a portion of our money ready at the bank for whenever we need to withdraw it. Even if depositor A wanted to withdraw the entirety of his 100$ account, the bank would give him the liquidity it had reserved for depositors B, C, D, E, F and G simply because those depositors don’t need their money right away. 

But if depositors A through G all run on banks at the same time, where does the bank find the money? 

It is invested. It is invested in housing loans, student loans, car loans that the same depositors have all taken out but more importantly, it is invested in Lebanese government bonds. 

The bank now has 2 options. First, it can sell off the loans it holds to other banks and sell the bonds they hold in a bid to find some liquidity, or it can tell the depositors that they should come back later. The latter option, in any rational banking sector, amounts to a declaration of bankruptcy and insolvency on the bank’s part. 

With the worsening of the economic and financial situation in the summer of 2019, banks had to meet the demands of their depositors requesting to transfer their money out of the country. Imagine 1000 deposits, each worth 1 million dollars. No bank would ever carry $1 billion in cash because of its opportunity cost, that is, the interest that they are not making off investing the money. When prompted with transfer-out requests of $1 billion, banks dumped their positions to find the cash they needed in order to transfer the money abroad, thereby eliminating all the ­“high quality” securities that they were holding. 

When the crisis became deeper, banks had run out of high-quality securities that could be easily liquidated for a reasonable price and thus had to resort to selling off their junk bonds at a significant loss, wiping out large portions of their capital. Then came a time where the banks couldn’t even sell these junk bonds. They essentially ran out of things to sell and could not come up with the money you’ve asked for anymore. 

Think about it this way: Depositor A has requested the transfer out of his $1 million account at the bank. With that money, the bank has bought $500.000 worth of US treasury bonds, $200.000 worth of Lebanese Eurobonds, $200.000 invested in Lebanese lira-denominated treasuries and has $100.000 at the central bank as required reserve. In the summer, banks offloaded $500.000 of US treasuries that it had purchased with depositor A’s money but also offloaded $500.000 of US treasuries from depositor B’s money. When depositor B asked for his money, the bank offloaded the securities purchased with depositor C’s money. And it keeps on going until nothing is left to unload but junk bonds. Banks are left with worthless Eurobonds that they can’t sell to give depositor Z his cash and ask him to “come back tomorrow”

“Imagine a bank’s FX liquidity as a water tank” said a banker from one of Lebanon’s Alpha Banks. “The tank is draining because people are withdrawing their money, and nobody is filling the tank back up again.” This, ladies and gentlemen is a stark example of what is called poor liquidity management. 

Banks should be able to meet a minimum amount of withdrawals in order to remain solvent and should thus maintain a diversified portfolio of assets, not Lebanese Eurobonds or treasury bills that are selling for pennies on the dollar… 

What is meant here is that if a bank purchased a Eurobond with 100$ face value for 90$ and now has to sell it off for 5 (because no rational investor would purchase it for 90$), then the shareholders of that bank have lost 85$ trying to provide you with your money. If this phenomenon repeats itself for all depositors, the bank will run out of things to sell off, amounting to a fully-fledged bankruptcy. This is the importance of carrying relatively risk-free assets and ones that can be sold instantly and at a fair value. You need to be able to sell these assets fast in order to provide your depositors with the liquidity in case they need it. 

With high risk comes high return but the oftentimes forgotten variable is also low liquidity. Paired with exorbitant interest rates on deposits, this poor liquidity management has pushed the entire financial sector to the brink of collapse.