I wanted to elaborate a bit on some of the themes in our last piece. Given the recent failure of First Republic, it is clear that the liquidity crisis in our banking system remains acute.
One of the lessons I learned as a young trader was to “do the trade you identified.” So, in other words, if you think oil will go up in price, then buy some oil futures instead of say, shorting JetBlue, which exposes you to a bunch of risks you never intended to take. I constantly watched people do derivatives of the trades they had identified, many times because they could not do the direct trade. In any event, to the extent that we can, we really should stick to executing what we envisioned in the first place when we start moving money around.
What does this have to do with banks? Well, most of us put money in the bank for two reasons. First, so that we can use it. Second, so that it will be safe until we need to use it. The question is, given our reasons for putting money in the bank, does a bank accomplish our goals, or are we unwittingly putting on exposure to risks that have nothing to do with our intentions?
Many of you know that in addition to my financial endeavors, I also started an entrepreneurial venture, the world’s first pro flag football organization. Start-ups are not easy, folks. You know what else is not easy - using your money when you are a start-up with bank deposits. You see, we don’t fit into the box of a “normal” business., We go for long periods without much cash in the bank, then we raise some money, then we use that money to grow our business. And that kind of pattern trips every anti-fraud wire that the banking system has in place. When we are fortunate to have capital at our disposal, our CFO is pulling his hair out because everything we do, every wire, every attempted credit card charge, leads to a fraud alert. Every day we say to each other - why isn’t there another way to manage our cash so that we can use it?
Why did so many start-ups and other corporations have bank deposits over the $250,000 FDIC insurance cap in SVB, Signature, First Republic and other institutions? So they could USE it. No attempt at earning returns, here. One simply must have a bank account to participate in the system - to run payroll, to pay suppliers, to pay service providers.
That brings us to the second reason we deposit money in the bank - safekeeping. Way back when, there was this concept that money was backed by gold and that gold was the basis for most wealth. And, if you had a bunch of gold - lucky you! - then keeping it at your house was a pretty bad idea. And if you think about all of those grand old bank buildings that we now use for event spaces and Apple stores, their defining characteristic is that amazing safe. A bank was your own version of Fort Knox. Bonds were also physical instruments. Bearer bonds were like cash, valuable to the holder, regardless of whether the holder was the owner. Great asset to keep in a vault.
Once our wealth digitized, we didn’t really need banks for safekeeping any more. What we see now is the phenomenon where depositors are actually LESS safe in a bank, then they would be with a number of alternatives, like a money market fund managed by Franklin Templeton or Fidelity.
Balance sheet 101 goes like this. The bondholders own the company. They make a preferred return and have the ability to gain control in times of trouble. The stockholders own an option on the company. They have limited downside if things go poorly, but unlimited upside if things go well. In exchange for their short-option position the bondholders, like all sellers of options, get paid. I recall a business school professor of mine who once said: “Being a lender is really dumb. You give people your money and hope they give it back.” Well, at least bondholders get paid for taking that risk. The crazy thing is depositors take the same risk that bondholders do generally, except they get paid mostly “in kind” via utility and safekeeping, both of these services we have established are not really worth very much. There is no bank in the world that pays a high enough yield on uninsured deposits to allow the depositors to hedge their embedded equity risk by buying back the options they are short.
So, what happens next? Well, the market is going to speak. Markets always get these concepts before regulators do. Hence, a few hundred billion dollars left the banking system in the last few months to go into money market accounts, where the money both earns a higher return and is safer. See, people are pretty smart. Confronted with that sort of value proposition, they do the right thing. Every time.
Apparently, the regulators are not happy about that recent trend. They are wondering how to keep the banks alive if it continues. And I am wondering why we need to keep the banks alive at all. There was a time, before the development of securitization, or the high yield bond market, when financial institutions were the only game in town for debt capital. Those days are long gone. Why do we actually need banks today? What purpose do they serve when money becomes increasingly virtual instead of physical?
Fed data from December of 2022 showed the following:
$6.7 Trillion Corporate Bonds
$3.1 Trillion Corporate Loans (non-banks)
$1.5 Trillion Corporate Loans (bank porfolios)
$8.9 Trillion outstanding Agency Mortgage-Backed Securities
$2.3 Trillion outstanding mortgages (bank portfolios)
$1.1 Trillion outstanding mortgages (non-banks)
We can see that from a liquidity perspective, the economy can do quite nicely without banks, since they pale in size compared to the securitization and private markets in total. From a storage and use perspective of money, we have already seen the better future, it’s called a stablecoin.
A stablecoin is an entry into a database that entitles the owner to value. The first stablecoin to earn great market share is called PayPal. I presume you have heard of it. I promise that if you want to sign up as a paid subscriber for Unintended Consequences, that you can use PayPal to instantly and without cost (we are “friends,” of course) transfer money to me. PayPal maintains a private ledger and, in theory, holds all the dollars we transferred to them in exchange for those ledger entries that say we own some value in dollars. PayPal works because we trust them. Our experience says that it works, and that we can use these digital dollars really easily - almost everybody in the world accepts them. Starting to sound pretty good, compared to the bank. No complex asset/liability issues to worry about, simply the concern that PayPal is actually honest.
Now, imagine that we could have PayPal, but not have to trust them. That’s what a stablecoin can do. Once we digitize all of the assets in the world - and that process has started, folks - a stablecoin issuer can maintain an open ledger that shows in real time exactly how many assets they have and exactly how many liabilities.
The job of the stablecoin issuer is to manage those assets so that we have confidence that they will always be worth a dollar - which sounds rather similar to what Fidelity, Vanguard and Franklin Templeton do every day managing money market accounts.
Existing stablecoins are happy to pay out zero and earn money market returns on the other side. If they did pay a yield today, that would probably increase the likelihood that US regulators would define them as securities. So the issuers pay zero.
But, once the authorities figure out the regulations for stablecoins (a bill was introduced last month in Congress) and those issuers have to go through KYC/AML and make other disclosures, they will start to pay a yield because at that point, why not? Maybe paying for deposits will get some market share.
After a quick race to the bottom, the average stablecoin will probably pay between 25 and 50bps less than money market assets. In other words, the same yield that money market funds pay. So, let’s just say that you can effectively use money market funds as money, and that you can do so instantly and without friction. How does that sound compared to having your money in a bank? Hello Fidelity stablecoin, bye-bye J.P. Morgan Chase checking account.
As of March 31, 2023, according to their quarterly financial statements, Citibank had $1.3T of deposits, or 60% of their liabilities. Deposits are 6.5x larger than Citi’s book equity. If people don’t leave money in the bank, Citibank cannot operate. Period. They actually have very little margin for error.
In the first quarter, Citi had a Net Interest Margin (NIM) of 2.4%. Their average cost of deposits was 2.7%. The 3 month US Treasury Bill yield ranged from 4.3 to 4.9% during Q1. Raising their deposit rates to 25bps under T-Bills, simulating the effect of being forced to compete with stablecoins that pay money market fund rates of return, would eliminate over half of Citibank’s NIM.
Let’s face it. We needed banks when our physical valuables needed safekeeping and banks were the primary source of credit in the financial system. They no longer serve those or any other meaningful purpose. Get ready for a very, very big change.