Which banks are riskiest? Where to deposit my savings?

August 29, 2008

A bank has a number of sources of income: Interest income from commercial, consumer and mortgage loans, fees for usual services such as transfers, safe deposits, currency exchange, and others, but by far an ordinary bank’s activity is concentrated in greatest part in paying and receiving interest.

Thus, there are a number of ways in which a bank’s income may be constrained. A flat or inverse yield curve, unfavorable economic conditions, loss of confidence in the bank itself or the banking system in general, excessive competition, or excessive regulation, and restructuring are some of them.

Of all these the most vital is confidence. It’s common knowledge that in the fractional reserve system, a bank never has enough cash or equivalents to satisfy the demands of all of its customers at a time. The expectation is that under normal circumstances, when the public has confidence in the banking system as a whole, most individuals will be disinclined to withdraw funds before maturity, and the bank can therefore use most of the deposits to lend and expand activity in the economy, which is to the benefit of everyone.

In those rare situations, however. when banks do lose the confidence of their clients and insecurity pervades the financial system, the benefits that the fractional reserve system provides to the economy contribute to the creation of a vicious cycle in which the more people lose their money, the more people lose their confidence, and even those banks with relatively solid balance sheets cannot escape the consequences.

And, for more sophisticated banks that are or were more active in such novel activities such as securitisation and the derivatives markets, the risks and problems are likely to be more complex and painful. New instruments that have not been tested before under conditions of stress often lose their entire credibility once panic prevails. The heroes of yesterday are likely to be demons of today, and, as a it is so often emphasised, past performance is in no way a guarantee of future gains.

What are the signs of a bank that may be in difficulty meeting its obligations?

Perhaps the crucial point to comprehend is that in times of financial trouble the vast majority of financiaL participants will attempt to reduce risk exposure. In crisis times emotions overtake reason, and volatility across all asset classes rises, often to unusual levels. This results in a loss of predictibility, as a financial actor is more and more unable to discern the future direction of his investments. Less predictibility necessitates less leverage, and consequently less trade, less interest, less earnings, less revenue, less optismism, and more savings, more losses. more reserves, and fear and pessimism.

Interest rates are the best expression of market participants’ risk perception about an institution. The more risk the market perceives about an actor the more risk premium he has to pay, even more so in an environment where traditionally less favored intruments such as the treasuries attract much greater than usual interest. Usually, the investor is willing to accept a lower return for safety, and this creates a kind of herding behaviour, in which those that are safe gradually become the safest, while those that are more risky, in time lose all their credibility. In other words, a credit or banking crisis is likely to drive the interest rates of those banks with the safest assets lower, while those with the riskiest balance sheets will find themselves paying higher and higher, until some of them suffer such high costs of funding that they’re forced to become bankrupt.

A prudent person will not take risks during a severe banking crisis. Crises always end – there will be far more opportunities once the coast is clear, so to speak, and with much less risk. While there are those who do successfully invest at a time of trouble and receive great returns, of all those who try to do this, those who achieve success are a tiny fraction. The idea of investing when everybody is selling has burned more homes than it has built. Shorting is, of course, a viable way to profit from the crisis, but only if one has discipline and confidence to survive the periods of inevitable euphoria.

To summarise

1. High interest rates
2. High loan to risk capital ratio
3. Cheap stock price (penny stock, very low p/e ratio)
4. Rumours

should be avoided when choosing a bank.

Savers should shun those banks that were most active in mortgage lending activity during the heated days of the real estate bubble. They should also avoid those that are subject to rumours – in a banking crisis, even a strong institution can be a victim of rumours, and with surprising speed. While Indymac wasn’t a strong institution by any stretch of the imagination, the speed of its demise demonstrates the might of the rumour mill.

What are the signs of a turnaround, or end to the banking crisis and recession?

1. As indicated by Alan Greenspan, a narrowing of the LIBOR spread to 25 over the FED funds rate.
2. At least a twenty percent lessening of tightening for mortgage loans by banks,
3. A bottom in the stock market, preferably a double bottom
4. A twenty percent decline in bank failures from their peak.
5. An end to house price falls

We’re nowhere near these, as of yet.

More posts related to this subject are here and here


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