The structural footprint of a bank run

**Patrick McKenzie** (0:02)
Welcome to Complex Systems, where we discuss the technical, organizational, and human factors underpinning why the world works the way it does.
Hi, everyone. My name is Patrick McKenzie, better known as patio11 on the Internet. In the model we teach to children, banks take in money from savers, make loans, and collect to spread. The actual funding of banks is rather substantially more complicated than this gloss, but taking deposits to make loans remains very important, in particular because of some financial consequences of it. We call this activity and the consequences of it, the deposit franchise. It failed to function as expected back in the 2023 banking crisis. So I'll read a mid-crisis essay about the deposit franchise and update it with the benefit of hindsight. Deposit Franchises is Natural Hedges, originally written for Bits About Money, May 5th, 2023 It has been an eventual few weeks since the start of the banking crisis. We recently lost another previously well-regarded, well-managed risk-first bank, First Republic. We will likely lose more, potentially many more. And so many now have a simple question, why? There were actually a few bank closures after First Republic, but we thankfully averted a wave of closures that was very much not a given at the time. Return to the essay. After some bloviating by institutional actors early in the crisis, consensus is slowly pivoting from an indictment of individual banks management teams to recognition of a structural issue. When interest rates rise, asset prices fall. Banks loaded up on good assets in the low interest rate environment, while flushed with deposits. Interest rates rose, banks became notionally insolvent or close to it, and deposits fled in a series of classic bank runs. The only thing new under the sun is the size and speed of the deposit flight.
A few weeks ago, this was blamed on concentrated depositor basis, all talking to each other on WhatsApp, and maybe some shadowy cabal-like behavior by VCs. This explanation grows more farcical with each additional failure. So without admitting that they were previously talking out of their hindquarters, opponents and regulators are now focused on mobile apps.
I am darkly amused as a sometimes financial technologist that putatively serious people think that load latency telecommunications technology is an exciting and unprecedented development for finance. My brother in prudential regulation, do you know why we call it a wire transfer?
Anyhow, many, including those in corridors of power, are extremely perplexed that interest rate risk could surprise bank management teams of all people. The essence of banking is, of course, maturity transformation, borrowing short and lending long. This necessarily exposes banks individually and the banking sector as a unit to interest rate risk. Moreover, banks are levered to that interest rate risk because, of course, they are. How could banks not have known, et cetera, et cetera? Matt Levine has an excellent explanation of two financial theories of banking, one in which this risk is front and center and one in which it is swept under the rug.
I have not seen a sympathetic explanation of how well-intentioned, smart people could actually intentionally take the risks that resulted in the present banking crisis.
Past advocates for that risk-taking might be understandably reticent about advancing their arguments for raising on the flop, now that we've seen the river. So I thought I'd provide a sketch of the world as we understood it until very recently. Brief disclaimer, I'm an advisor at Stripe and previously worked there for many years. Stripe doesn't necessarily share my opinions. I was also a depositor, creditor, and shareholder first for Public Bank until their receivership. They never gave me anything other than their standard publicly available offers, but their standard offer was quite generous. If you're curious about it, you can read Requiem for a Bank Loan in Bits About Money. Natural Hedges Most readers will be familiar with the concept of financial hedges, an instrument designed to cover an exposure that one has but doesn't want. There exists many different instruments that can be used for this purpose. See the rest of the Internet or your financial advisor of choice for much more on this topic. After you have the concept of a financial hedge in your mental toolbox, extend that to the concept of a natural hedge. Instead of opening up Excel and doing complicated financial engineering, you have an exposure which is structurally equivalent to a financial hedge, but caused by how your life or business interacts with the world. Perhaps an example will help clarify. Many businesses in Japan have an unwanted exposure to currency risk, specifically on the yen US dollar pair. The value they produce in the world is mostly denominated in yen, and their obligations to shareholders are mostly denominated in yen. But important costs for their businesses, like commodities sourced overseas, are denominated in dollars. In futures where the dollar appreciates against the yen, they suffer windfall disutility. They didn't set out to be currency speculators, but suffered anyway because that is the hand the world dealt them.