One of the most important lessons from the credit crisis is that so called “core deposits,” consumer savings and demand deposits, aren’t really “core” when you most need them, when the bank is in trouble. This post gives some examples from the credit crisis and discusses implications for best practice liquidity risk and interest rate risk management.
The demise of Lehman Brothers and Bear Stearns reminded us, as Ben Golub of BlackRock noted the other day, of “lessons that should have been remembered” instead of “lessons learned.” Those two institutions were classic cases that illustrate something that’s been proven the world over. You can’t be a big lender if you are funding the loans with wholesale funding from the capital markets. That’s why this long list of famous names has disappeared over the last three decades:
- Bankers Trust Company
- Continental Illinois
- First Chicago
- Industrial Bank of Japan
- Nippon Credit Bank
- Long Term Credit Bank of Japan
- Long Term Capital Management
Long Term Capital Management differed from the others only in that it chose to be a lender without a bank charter. One of the rare exceptions to the rule was GE Capital, which grew into a $600 billion asset lender funding with bonds and commercial paper. As we all know, it was only government intervention in the commercial paper market that prevented GE Capital from joining the ranks of the dear departed wholesale-funded lenders.
The Darwinian process that has played out in financial services after watching the demise of this business model has resulted in a strong consensus. Major lenders need to have a heavy base of retail deposits, ideally “core” savings deposits and demand deposits that are “non-maturity” deposits with no explicit maturity date. The second best class of deposits is retail certificates of deposit with explicit maturity dates, but, in the minds of most bankers, a very high probability of rolling over. Countrywide Financial Corporation recognized this as it scrambled to grow its banking subsidiary as a stable alternative source of funding to the capital markets. We described what happened to Countrywide in a number of blogs, the most recent of which is this one:
van Deventer, Donald R. “An Appreciation: APRA’s Prudential Approach to ADI Liquidity Risk,” Kamakura blog, www.kamakuraco.com, September 28, 2009. Redistributed on www.riskcenter.com on September 29, 2009.
In that blog, we showed the graph of Countrywide’s outstanding commercial paper as a function of the five year credit default swap spreads on Countrywide:
Once the quoted credit default swaps for Countrywide broke through 100 basis points per annum, the firm lost 100% of its commercial paper supply within 6 months. By coincidence, I signed the visitors’ register at the Calabasas, California head office of Countrywide on August 15, 2007, just below entries for lenders from Bank of America and Citigroup. That was the day Countrywide took down its full $11.5 billion in commercial paper back-up lines to deal with its funding problems. In the end, Countrywide Bank hadn’t grown fast enough to allow the firm to reduce its reliance on wholesale funding, forcing a sale to Bank of America.
A month later, the smile came off the face of bankers whose funding was predominantly “core deposits.” The scene below played out in the lovely Northern England town of Newcastle, headquarters of the mortgage-focused bank Northern Rock. Retail depositors of the bank lined up in droves to withdraw their deposits on September 15, 2007. Why? The bank had never reported a loss on its financial statements prior to that date. That may well be, but retail depositors of the bank recognized that home prices in the U.K. were falling and that Northern Rock, as one of the most aggressive mortgage lenders in the nation, was very much exposed. They voted with their feet, and this run triggered intervention by the Bank of England. Unfortunately, that wasn’t enough to stop the run as one can see from the graph below. Between June 30, 2007 and December 31, 2007, Northern Rock lost 63% of “customer accounts.”
This happened in spite of 28 billion pounds sterling of support from the Bank of England, which was forced to make its first bank rescue in 140 years.
“That’s irrational,” one U.S. bank examiner said to me in 2008. “Why would depositors flee even in the presence of full government support?” I felt like I was forced to tell Virginia there was no Santa Claus. “I know it will come as a surprise to the 150 lovely bank examiners in this room, but the average bank depositor would rather deal with you in a social capacity, not in a professional capacity. If all they have to do is walk across the street to another bank to avoid meeting you in your professional capacity, they will do so.”
This sad state of affairs was confirmed on July 11, 2008 when this bank run took place at the Pasadena, California offices of the heavily mortgage-oriented IndyMac Bank, itself a one-time spin off from Countrywide:
Again, government deposit insurance and government support were not enough to stave off the retail run on deposits that effectively ends the existence of a major financial institution. Ironically, in the 2007-2009 credit crisis, it has been retail depositors that have put the stakes through the hearts of financial institutions like Washington Mutual and Wachovia. If it’s merely bond holders and commercial paper investors, the government shows restraint and keeps the institution on life support in most cases (AIG, Citigroup, Bank of America, FNMA, FHLMC) but not all (Lehman, Bear Stearns). When Grandma Brown, however, says “I’m out of here,” it was all over for Kerry Killinger at Washington Mutual. This is what happened to Kerry:
“On September 25, 2008, the United States Office of Thrift Supervision (OTS) seized Washington Mutual Bank from Washington Mutual, Inc. and placed it into the receivership of the Federal Deposit Insurance Corporation (FDIC). The OTS took the action due to the withdrawal of $16.4 billion in deposits, during a 10-day bank run (amounting to 9% of the deposits it had held on June 30, 2008).] The FDIC sold the banking subsidiaries (minus unsecured debt or equity claims) to JPMorgan Chase for $1.9 billion, which reopened the bank's offices the next day as JPMorgan Chase branches”
This quotation is from a longer history of Washington Mutual on www.wikipedia.com:
The same fate quickly befell Wachovia according to the Charlotte Observer:
“Inside Wachovia, executives started noticing customers withdrawing money on Friday morning, following the failure of Washington Mutual on Thursday. “The so-called silent run on the bank – it’s real,” Carlos Evans, Wachovia’s wholesale banking executive, said in an interview. “When Congress failed to pass the ($700 billion bailout) proposal, when WaMu collapsed, you could see the money flowing. My computer screen was lighting up.”
“Starting Friday morning, Evans said, businesses and institutions with large accounts started withdrawing money to lower their balances to below the federally insured $100,000 limit. They weren’t closing accounts, he said, adding “they were very apologetic in saying they love the service they get from Wachovia and they weren’t leaving Wachovia. They were just moving their money until things settled down.”
“Money flowed out of Wachovia throughout the weekend, said Evans who heard anecdotes and received memos and BlackBerry messages from bank employees in the field.”
“What happened last week, and it literally happened that fast …You could go from being OK, hurt, weakened, there's no question the company was weakened… but you go from being weakened to in trouble in a matter of days,” he said. “I don't think people understand how quickly events unfolded.”
“The FDIC and the OCC declined to comment on whether the bank experienced a run on deposits. However, FDIC spokesman David Barr said it wouldn't be surprising. ‘When a bank in the news is rumored to be in trouble that does prompt a lot of depositors to take a second look at their deposits,’ he said.”
Implications for Liquidity Risk Management and Interest Rate Risk Management
These recent stories are a reprise of what happened in the savings and loan crisis in the 1980s, in which institutions crippled by a different macro-factor (interest rates instead of home price declines) were paying 200 or 300 basis points more than their safer competitors and still suffering serious runs of deposits even though these deposits were almost completely insured by the Federal Savings and Loan Insurance Corporation. Most bankers have not dealt with this risk of failure in a realistic way, myself included. In 1996, my colleague Robert A. Jarrow and I published this article:
Jarrow, Robert A. and Donald R. van Deventer, "Power Swaps: Disease or Cure?" Risk Magazine, 9 (2), February 1996. Reprinted in Structured Products, edited by Dilip Madan, RISK Publications, 2008.
The innovation in this paper was that it was one of the first papers to apply modern risk-neutral valuation technology to non-maturity deposits like demand and savings deposits. After assuming the functional form linking open market interest rates to deposit balance volumes and deposit rate levels, we were able to value the resulting stream of cash flows subject to one important assumption: that the deposits were risk free because of federal deposit insurance. What we failed to capture completely was the very substantial termination in the supply of deposits at “below market” rates in the event that the credit risk of the institution rises substantially, even in the presence of government deposit insurance. Professor Jarrow addressed this more directly in the Federal Deposit Insurance Corporation’s loss distribution model (published December 10, 2003), where it was shown that a financial institution’s CAMEL regulatory risk rating was statistically significant in predicting deposit volumes. As the risk of the institution rose, as measured by the CAMEL rating, deposit volumes would be lower all other things being equal.
The implications of this for liquidity risk management, capital adequacy, and interest rate management are huge:
- The supply of deposits, even retail bank deposits, are tied to the same macro-economic factors that drive the value of assets
- This is because the impairment of asset values increases the credit risk of the bank. Retail depositors perceive this very rationally and flee even in the presence of government deposit insurance
- Because of this, the actual liquidity risk and bankruptcy risk of the bank is MUCH higher than would be shown using deposit balance projections that ignore the impact of credit risk on deposit supply
- Moreover, for an institution that has never been in serious credit difficulties, its own balance history is not enlightening in helping to understand what would happen to deposits if the bank got in trouble. In fact, the deposit histories of banks that have failed are much more relevant than data from a “living” bank
- Finally, from an interest rate risk perspective, measuring the value of deposits using a traditional “tractor” or moving average interest rate less a spread will be a dramatically “rosey” scenario compared to the true risk. As Northern Rock found out the hard way, 63% of deposits evaporated in six months even with government support.
- Measured correctly, using credit risk links to deposit volumes, banks have much more risk and “core deposits” are much less valuable than a traditional analysis would show
More and more, bankers are using “best practice” default probabilities from a service like Kamakura Risk Information Services to correctly reflect the true credit risk sensitivity and liquidity risk of their own deposit franchise.
Donald R. van Deventer
Honolulu, December 15, 2009