Bank to basics

Special Situation Investing

Bank to basics

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Bank to basics

Today's show is an inquisitive essay vs our normal investment thesis. We explore the nature of a social media banking debate and look for ways to improve the quality of our own thinking

Six Bravo

Mar 25, 2023

“Bad terminology is the enemy of good thinking.” - Warren Buffett

Welcome to Special Situation Investing Episode 70 where we hope to jump-start your investment research through our own short and shareable content.

Full disclaimer before we begin, this particular write-up does not end with an investment thesis but rather takes the form of an inquiry to spur further thought around a topic. Specifically, today’s topic is banking and it’s a topic that’s all over the news given recent developments at Silicon Valley Bank, Credit Suiesse, Signature Bank and others. We are by no means banking experts but think that a few broad and insightful principles can be gleaned from the thirty thousand foot perspective of a generalist.

To begin, the topic that spurred our investigation was the juxtaposition between two recent Fed decisions which seem, on the surface, quite contradictory. The first decision took place on the 22d of February of this year when the Fed Board unanimously voted to deny Custodia Bank’s request for reconsideration to become a member of the Federal Reserve System. Use of the word, reconsideration, was intentional as Custodia Bank had previously been rejected for Federal Reserve System membership on the 27th of January. The rejection of Custodia Bank’s application was followed, at the next Fed vote on March 12th, with the invoking of a systemic risk exception for Silicon Valley Bank and Signature Bank.

To put it plainly, the Fed rejected an application from Custodia Bank, who’s business model is to maintain 100% of demand deposits in cash, just before it voted to bail out Silicon Valley Bank which did not have the cash on hand to meet customer demands.

That those two Fed decisions were unanimous, proximate, and seemingly apposed to each other generated no small amount of discussion on social media in recent weeks. The obvious question is, why would the Fed reject Custodia Bank, who’s deposits are fully reserved, if the very purpose of a bank is to safeguard client deposits? That the Fed’s need to intervene in the banking system could have been avoided, had banks been fully reserved like Custodia Bank, only highlights the seemingly incongruous nature of the Fed’s decision making process.

Recent comments from Secretary Yellen added to the confusion when she said, “I can reassure the members of the committee that our banking system remains sound, and that Americans can feel confident that their deposits will be there when they need them." She added, "This week's actions demonstrate our resolute commitment to ensure that depositors' savings remain safe."

So which is it, is the banking system sound, are the deposits safe? Should Americans be “confident that their deposits will be there when they need them, bailout” or are their deposits even there? If my deposits are in the bank then my confidence in them is not needed because they are there regardless of my confidence. If my deposits are not there, then the confidence of Americans is very much needed in order to prevent a run on the bank.

Again, an institution simultaneously engaged in bank bailouts and media campaigns to shore up confidence in banks, had only weeks before rejected a fully reserved bank application. An application that, had it been approved, would create a bank free from the possibility of a bank run and without need of any confidence in its deposits. So what’s going on here, is the banking system sound and if it’s not sound then why not approve a fully reserved banks application and shore up the systems soundness?

Perhaps this is where the cheesy title of today’s show comes into play—Bank to Basics. It is basic procedure in high school debate to first define your terms. After all, if we use the same word but mean different things by it we will forever talk at cross purposes. So, let’s first define what a bank is. According to Websters Dictionary, a bank is: “an establishment for the custody, loan, exchange, or issue of money, for the extension of credit, and for facilitating the transmission of funds.”

Breaking this definition down may enlighten us as to why the Fed’s perspective is so divergent from an army of impassioned twitter users.

Beginning with the first part of the definition, a bank is established for the custody of money. We’re only one term into the definition and already we can see where each party’s understanding of the term differs. The average bank customer understands this statement to mean that the bank has all of their money safely stored away in a vault. The Fed, on the other hand, very clearly states the opposite. In fact, federal banking regulations explicitly stipulate formula to determine the type, quality, and amount of reserves a bank must maintain against deposits in order to be considered properly reserved. None of these calculations would be necessary if the bank was fully reserved and yet the calculations and regulations do exist. This can mean nothing other than that the Fed wants a fractional reserve system.

Taking some license to speculate, Custodia Bank’s fully reserved model has mass appeal to customers who believe that all of their money is secure in the bank but strikes the Fed as, not a bank at all. The very regulatory system created by the Fed is predicated on fractional reserve banking wherein a portion of depositors money is held in cash reserves while the majority is loaned out or earning interest via the purchase of treasuries and other fixed income securities.

To further speculate, it would appear that the Fed views the banking system as an extension of their own monetary policy. The Fed’s best known tool of monetary policy is interest rate adjustments but control of the money supply is an equally powerful, if slightly less well known, tool. As we all know, whenever a debt is created on one side of a transaction a credit appears on the other. The newly created credit can be traded as if it were cash and is backed by the confidence that the creditor has in the debtor. This is essentially what treasuries are, government debt that trades like money because of the confidence placed in the nation that issued it.

Therefore, if the Fed expects banks to participate in regulation of the money supply through the lending of deposits, why would they approve a fully reserved bank? When the Fed hears “bank” they consider the full definition of the word which includes “the custody, loan, exchange, or issue of money, for the extension of credit.” The key words here are loan, issue of money, and credit, activities which the Fed no doubt expects banks to engage in. Banks that engage in these activities, however, undercut the layman's understanding of a banks purpose, which is to safely secure depositor funds.

If we revisit Secretary Yellen’s statement we’re reminded that she encouraged confidence in the “banking system.” She is well aware that banks are not fully reserved, and most certainly did not want fully reserved banks during her tenure at the Federal Reserve, because she understood that fractional reserve banking is itself a policy tool of the Fed. Fractional reserve banking is a critical component of monetary policy as evidenced by Chairmen Powell's statement on the 22nd of March when he clarified that “tightening credit conditions in the banking sector had the same effect as would increasing interest rates.”

An analogy could be employed to further illustrate the point. Consider an individual who wants to store ten gold bars in a vault. This individual is only interested in the security of their gold and is happy to pay a fee for that security. In this case, the owner of the vault does not lend out customer deposits for income, he simply collects a fee from the depositor in exchange for securing his gold. Let’s further assume that the owner of vault approached the Federal Reserve to seek a license as a regulated bank.

More than likely the Federal Reserve would not grant the vault owner a banking license. From the Fed’s perspective the vault owner’s proposal is all risk and no reward. This is because the fully reserved vault would not assist the Fed in its efforts to adjust the money supply and at the same time would expose it to the risk of association with a vault that could be robbed or mismanaged. This analogy clarifies the way in which our presuppositions and definitions can lead us to see the same set of facts very differently.

Now to be sure, there are many causal factors driving the current banking crisis and we’ve chosen to focus on only a few. We could have discussed interest rates, crypto regulation, inflation, or any number of other factors that play a role but thought that a deep dive on this particular point would be worthwhile.

By first defining our terms we’ve come to see that the Federal Reserve has no interest in sound banks if you assume that sound banks are those which hold 100% of depositors cash at all times. On the other hand, the Fed is interested in fractional reserve banks which assist them in managing the money supply provided they don’t take on too much risk in the process.

Warren Buffett put it best when he wrote that “bad terminology is the enemy of good thinking.” As investors, we should strive for the best thinking that we can achieve and step one in that process is securing a clear understanding of the terms involved. At best, clearly defining our terms results in clarity of thought but at the very least it prevents us from engaging in hours of pointless “debate.” Debate that is really just two people talking past one another.

Well, with that we hope you enjoyed Episode 70 of the podcast. Thank you for all of your support and please remember that you can easily stream bitcoin micro payments to us through Fountain or can be paid to listen to your favorite shows on the very same app. We hope that you gained some knowledge through today’s show and we’ll be back again next week with more original content.