Tuesday, July 15, 2008

Face it: banks are illiquid

What is the role of a bank? It takes deposits and lends them to borrowers, typically on business loans or mortgages. The latter have rather long maturities, deposits can be withdrawn at any time. In other words, bank perform a maturity transformation. Doing so, they take the constant risk of not being able to satisfy sudden withdrawals from deposits. Hence the help of central banks as lenders of last resort.

What this means is that no bank is liquid enough to satisfy the withdrawals of all deposits. In fact, if any bank would be able to do so, it would lose money, as it is paying interest on deposits that just sit idle in the vault. Thus any bank risks being subject to a run.

If Senator Charles Shumer reads this, I hope he will come to realize the situation and send letters about every bank in the US, or even every bank in the world, stating that the bank cannot honor deposits. Because this is true, and has always been true.


Vilfredo said...

Schumer did not write a letter about any bank, but one that was more illiquid than others. But that point that any bank could be hit by a run at anytime is well known, and this is the very reason the FDIC was created.

It remains that Schumer did act irresponsibly by going public with his letter.

Independent Accountant said...

IndyMac was insolvent. It's stock price went from $45.82 to $0.80 in the 20 months before Schumer wrote "the letter". IndyMac was on "death watch" for months. It is clear to me you are an "academic". I use the term as one of opprobrium. If you traded stocks you would have known about IndyMac a long time ago. All banks have "mismatched" maturities to some extent. So? I stand with Schumer against the OTS and FDIC. I have long believed you were not born in the USA. Did you live here between 1979 and 1986, the period of the S&L crisis? Even if you did, given that I suspect you are about 35, you didn't experience it in real time as I did. It is clear to me that the OTS and FDIC are in "full coverup mode". I saw this during the S&L crisis. For my money, right on Chuck Schumer!
I disagree with you too Vilfredo.

Vilfredo said...

independent accountant: IndyMac's situation was being taken care off. Initiating a bank run has benefited nobody and hurt some. It was a stupid move by Schumer.