When People Start Running on the Bank, Virtually Every Bank is an Inch from Zero

When People Start Running on the Bank, Virtually Every Bank is an Inch from Zero

Even the banks that saw this coming months ago couldn't prepare for this.

Runs on the bank are happening.  Many people and businesses (big and small) put deposits in banks well over FDIC limits.  Others have been well under.  When panic sets in, everybody gets scared. They move money from one place to another.  They are heading for the hills or just doing something to ease their concerns.

Banks don't hold their deposits in cash.  They don't expect runs.  They buy into long term instruments.  They borrow short and they lend long.   As long as the yield curve doesn't remain inverted for long periods of time, this is how they make money.   It is really that simple. 

The lending long can be through any sort of instrument, and banks have played with instruments that are tied to real estate and consumer credit.     We've all heard the terms - mortgage-based securities, collaterized debt obligation, etc.  In an ordinary environment, these are not bad words.  They are highly liquid securities.

Virtually every bank in recent years made mistakes (Wells Fargo seems to be the only one which didn't make any).  These mistakes were simple.  They bought too much of this stuff and they assumed that it would always be liquid.

Credit markets are scared and these things have been illiquid for months.  When these instruments become illiquid, it doesn't mean that they are worthless.   In the first half of 2008, banks were able to conduct business as usual, but were forced to write down the value of these instruments.

When people get scared or scurried and demand their cash back, the banks need to try to get the money to pay back depositors and they cannot do it by selling these illiquid instruments.

We've seen this happen with some major banks now - Wachovia and WaMu most recently.  Lehman and Bear were derivations of the same thing, except the depositors were largely institutional.

This only ends in one of two ways.  First, the runs just end.  That's unlikely, especially in the near term.  It may happen in a few months when everybody gets comfortable with the 6 or 7 major banks still in existence.

Second, somebody buys the illiquid securities to provide the banks with the resources to meet the depositors' withdrawal requirements.  Our government missed a chance to do this immediately and could have ended this right now.

If the Republicans in Congress can't see the need to do this, maybe somebody else can help the banks with liquidity.  Maybe it will be some other government.  Maybe it is Bill Gross and Pimco who can make a fortune on this.   Maybe it is TPG or some other major financial concern. 

Until we see something, I am afraid that we will see more bank runs and quick bank failures. 

Ari Socolow
Ari Socolow: Ari Socolow is the Chief Economist and Editor-in-Chief at BestCashCow. He is particularly interested in issues relating to financial literacy and bank transparency. Since co-founding this website in 2005, Ari has been frequently cited in the media as an expert on local and national savings accounts, CD products, mortgage and loan products and credit card rewards products.

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