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Banking on Failure: Banks versus Non-Banks (Part II)

WORLDWORKS by Joe PimbleyEditor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.

The previous excerpt for Chapter 4 discussed Government Bailout, Support, Regulation and Partnership.

Government Enforcement of Legal Contracts?

[su_dropcap style=”flat”]I[/su_dropcap]N SUPPORT OF our contention that banks are part of the government we have copiously cited Calomiris and Haber.[1] We consider the insights, research, and explanations of these authors’ “political bargaining” thesis to be excellent. We note, however, that Calomiris and Haber choose the word “partnership” to describe the government-bank relationship. We prefer our formulation – “banks are part of the government” – since it captures the government’s dominant position in the relationship and subliminally suggests why government’s first reaction is invariably to save a failing bank. Partnerships dissolve, but we’ve never seen a government admit error and terminate one of its agencies.

Calomiris and Haber state on a few occasions that a government-bank “partnership” is necessary since banks rely on government to enforce the legal contracts that are central to borrowing and lending and to the ability to seize collateral pledged to a loan.[2] The authors consider this reliance on sanctity of contract to be a distinction between financial and non-financial corporates. According to this view, the U.S. non-financial corporate entity IBM (International Business Machines Corporation) need not have a Calomiris-Haber “partnership” with government.

We disagree. Non-financial corporate entities, such as IBM in the U.S., absolutely need and rely upon legal enforceability of contracts. Such firms cannot raise debt or equity if investors do not have high confidence that the host government will respect their rights as creditors or shareholders. Preservation of the corporate entity’s physical, industrial, financial, and intellectual property rights regarding its assets are also absolutely necessary. The role of government in a free market is to provide such property and contract rights for individuals as well as financial and non-financial corporates. In our view, then, there is no distinction between banks and non-banks in this regard. Business entities, financial or otherwise, have no obligation to form “partnerships” with government to gain property and contract rights.

High Leverage

Chapter 2 introduced and discussed financial leverage and its relationship to failure risk for a business. Focusing on liability-to-equity leverage, high leverage means simply that there is a large amount of debt and other liabilities relative to equity.

Figure 4-1 shows a table of a selection of U.S. companies in different business sectors. At the top we place the two large banks Citigroup (Citigroup Inc.) and JPMorgan (JPMorgan Chase & Co.) while the so-called investment bank Goldman Sachs (The Goldman Sachs Group, Inc.) sits at the bottom. Two columns show the total liability and equity values for the most recent 10-K SEC (U.S. Securities and Exchange Commission) filings. Further columns show the month and year of the 10-K filing, and the liability-to-equity leverage ratio. In a comparison of this type, it is arguably more meaningful to record tangible equity rather than the straight equity of the balance sheet as we do here. For simplicity of discussion, we employ the latter.

Screen Shot 8

The leverage ratios of Citigroup, JPMorgan, and Goldman Sachs near 10 are high relative to the group of non-banks. Note that American Airlines (American Airlines Group Inc.) and United Airlines (subsidiary of United Continental Holdings, Inc.) have worse leverage measures, but these two airlines have very high risk of default. (We write the American Airlines leverage as “not meaningful” since the balance sheet equity is actually negative!) We include Kellogg (Kellogg Company), Campbell Soup (Campbell Soup Company), and Clorox (The Clorox Company) in this list since these companies are unusual for their extremely dependable earnings and franchise values. Firms with such exceedingly low asset risk can operate at higher leverage than other businesses. Our purpose in showing Kellogg, Campbell Soup, and Clorox is to note that high leverage is not surprising when investors view a company’s asset performance as being highly predictable.

Short-Term Funding

Chapter 2 also discussed the propensity of banks to favor short-term debt such as commercial paper and repurchase transactions over long-term debt. To show how banks differ from other firms, figure 4-2 shows the fraction of total liabilities that have maturity of 1 year or less (otherwise known as “current liabilities”). Two columns show the total liability and current liability values for the most recent 10-K SEC filings. A third column shows the ratio of current-to-total liabilities.

Screen Shot 9

This division into “current” and non-current liabilities, while publicly available, is not ideal for our purpose. The greatest risks of bank funding are (i) the very short-term liabilities (from overnight to 3-month tenor) and (ii) the degree to which the liabilities have shorter maturity than the firm’s assets. Simply showing the ratio of current to total liabilities does not address directly these risks. Thus, we take the numbers of figure 4-2 merely to be indicative of the difference in debt management between banks and non-banks.

Another element of interest in figure 4-2 is that customer deposits for Citigroup, JPMorgan, and Goldman Sachs fall within current liabilities. We consider this designation appropriate but will discuss the short-term versus long-term debate for the nature of deposits in a later chapter. Observation of figure 4-2 shows that banks do indeed employ short-term funding to a greater degree than the other businesses. The three banking institutions have short-term debt equal to or greater than 75% of all liabilities. The non-bank firms have much lower fractions of their liabilities in the short-term category.

Summary

Relative to non-bank businesses, banks enjoy government guarantee in the form of insurance for deposits and implied, though uncertain, backing for some other creditors. With bailouts and lending, governments and CBs also support banks more indirectly and to a greater degree than non-banks. Given these elements of the relationship between a government and its banks as well as bank lending to governments and the regulatory control that governments exert, it is reasonable to consider banks to be a part of the government. Through review of financial statement data, we also find that banks generally have higher leverage and shorter funding than non-banks.

[1] C. W. Calomiris and S.H. Haber, Fragile by Design – The Political Origins of Banking Crises and Scarce Credit, Princeton University Press, 2014.

[2] See, for example, the excerpt of chapter 12 of C. W. Calomiris and S.H. Haber, Fragile by Design – The Political Origins of Banking Crises and Scarce Credit, Princeton University Press, 2014: “[B]anks depend on the government to grant them legal rights and to enforce their contracts; thus banks are dependent even on weak governments in ways that nonbank enterprises are not.”

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Joe Pimbley
Joe Pimbleyhttp://www.maxwell-consulting.com/
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.

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