In letting money out, such as lending or otherwise investing, banks take risks. While banks exist to manage risk, they often simply stockpile it. This owes to the peculiar nature of bank assets, and to the continual tension between prudence and greed.
While on loan, a bank’s assets are employed elsewhere, albeit supposedly earning a return for the bank. This monetary game of musical chairs is a confidence game: if the music of optimism stops, banks can be caught without a seat.
One party’s asset is the other’s liability. But the yin-yang of financial accounting can be discordant. The dilemma for banks comes in the asymmetry of their assets and liabilities, which are a mirror to the balance sheets of the customers they serve.
The contractual loans a bank has made cannot be instantly altered, but customers can withdraw at any time. Thus, banking is itself risky, though that volatile tinder is lit only when confidence is lost.
When confidence quickly and broadly wanes in an economy, a bank panic inevitably ensues. This often creates a double whammy on banks, as customers withdraw their deposits, and the value of a bank’s riskier assets – bonds, company loans, and mortgages – drop precipitously.
If assets fall below liabilities, a bank is bust. To forestall such failures, banks maintain equity: capital that optimistically offsets any asset plunge.
Keeping capital close at hand is costly. Return on cash is zero. Liquid assets – like government bonds – yield a measly return, which is why they are so liquid: they are relatively risk free.
The low return on safe assets feeds an appetite for risk. This sets up an ongoing tension between stability and profitability, which bank managers are supposed to balance. Their repeated failure to do so lies at the heart of every financial crisis. A simple equation explains this.
Return on Equity (RoE) = Return on Assets (RoA) x Leverage
where: Leverage = Assets / Equity
The concept is straightforward. A bank increases its profit by increasing return on assets (RoA). Maximizing return on equity (RoE) means holding as few low-return, ‘safe’ assets as possible.
When RoA falls for all asset classes, banks have another way to boost RoE: increasing leverage. This is done by placing more bets through lending and investing, sometimes with borrowed funds.
Ramping leverage necessarily amplifies risk, as a bank has less equity to fall back on should it be called on to meet its liabilities: something which can happen on short notice.
RoE is in the bloodstream of every banker as the benchmark of performance. Practically all bank senior staff are rewarded on meeting RoE targets. This ensures maximizing short-term profits at the considerable expense of safety.
In 2007, the biggest banks in America and Britain – Citi and the Royal Bank of Scotland (RBS) – had leverage ratios of 50 when the 2008 financial panic hit. RBS at the time was the largest bank in the world.
A leverage ratio of 50 meant that the banks could absorb only $2 in losses on each $100 of assets. That was skating on thin ice if the volatile and risky mortgage market dropped, which exactly what happened in early 2008.