{"id":26697,"date":"2023-06-23T18:52:48","date_gmt":"2023-06-23T22:52:48","guid":{"rendered":"https:\/\/ifintechworld.com\/news\/banks-are-riskier-than-you-think-risk-free-banking-is-an-illusion\/"},"modified":"2023-06-23T18:52:50","modified_gmt":"2023-06-23T22:52:50","slug":"banks-are-riskier-than-you-think-risk-free-banking-is-an-illusion","status":"publish","type":"post","link":"https:\/\/ifintechworld.com\/?p=26697","title":{"rendered":"Banks Are Riskier Than You Think. Risk-free Banking Is An Illusion."},"content":{"rendered":"
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Risk-free Banking Is An Illusion<\/strong><\/h2>\n

Everybody wants a sure thing.<\/p>\n

While most people want a chance at excellent investment returns, very few are happy with the trade-off \u2013 the risk of loss.<\/p>\n

We don\u2019t want to lose. In Thinking Fast and Slow<\/strong>, Nobel laureate Daniel Kahneman explains that people are twice as unhappy with a loss as they are happy about a gain of the same size.<\/p>\n

Our politicians and institutions promise to deliver security and protect us from loss because we want them to.<\/p>\n

Banks, deposits, loans, and risk<\/strong><\/h3>\n

Banks (with Silicon Valley Bank (SVB) as a poster child) are an excellent example of the difficulties and unintended consequences that follow from attempting to eliminate risk. I wrote about this in an earlier article for Forbes.<\/p>\n

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We\u2019ll start with a summary balance sheet for SVB, one of the banks that recently became insolvent (went broke).<\/p>\n

SVB\u2019s $173 billion in deposits<\/strong> were liabilities<\/em>, amounts that SVB owed<\/em>. SVB borrowed these deposits (from its depositors), promising to pay them back on demand (whenever the depositors asked for them). The other liabilities ($22.4 billion) were mostly short- and long-term debt, money that SVB owed to lenders who were not depositors.<\/p>\n

SVB\u2019s assets, what SVB owned<\/em>, included $13.8 billion in cash, $120 billion in securities<\/strong> (mostly US Treasury bonds and mortgage-backed securities) and $73.6 billion in loans<\/strong> (SVB\u2019s loan customers included many startup companies).<\/p>\n

The right (liabilities and equity) side of the balance sheet also included $16.3 billion of shareholders\u2019 equity<\/strong>. Shareholders\u2019 equity is the difference between assets and liabilities.<\/p>\n

The balance sheet illustrates how banks work. When a bank is founded, the original shareholders contribute money to provide starting capital. Bank managers borrow money from depositors and lend it to companies and other borrowers, hoping to make a profit by charging higher interest rates on their loans than they pay on their borrowings, including deposits.<\/p>\n

If the bank makes a profit, shareholders\u2019 equity increases. If the bank loses money, so do the shareholders, as shareholders\u2019 equity declines. If the bank loses too much money, the deposits and other liabilities that the bank owes will be larger than the bank\u2019s assets. The bank won\u2019t be able to pay back what it owes. Shareholders will lose their entire investment. Depositors might lose money.<\/p>\n

Said slightly differently, shareholders\u2019 equity absorbs the bank\u2019s loan losses until it is exhausted. Beyond that point, depositors\u2019 funds are at risk.<\/p>\n

Two fundamental sources of instability<\/h2>\n

Depositors and bankers have very different beliefs about how banks work. Depositors\u2019 beliefs are at best inaccurate.<\/h3>\n

Depositors think that their money is safe \u2013 maybe in a safe-deposit box that magically pays interest. The very language (\u201cdeposit\u201d) conflicts with the reality. Two definitions from Oxford Languages via Google
\n GOOG
\n <\/fbs-ticker> make the point (I have added emphasis in bold italics)<\/em><\/strong>:<\/p>\n