Banks & Sovereigns - Why are they so intertwined?

Occasionally, I am asked why I care so much about a bank’s parent sovereign when evaluating them. Here’s a short comment on why I believe the two are strongly interrelated and why bank risks cannot be considered in isolation of their country. This is from the perspective of a market practitioner rather than a regulator or academic.

There are five essential connections between modern banking systems and their host country that makes the two systems vulnerable to shocks between each other. These connections include:

•                     Fractional Reserve Lending

•                     Central Banking

•                     Fiat Money

•                     Depository Insurance

•                     Regulatory Control

Fractional reserve banking means that banks can take in deposits and subsequently loan out most of the funds, while keeping only a small percentage as cash in their vaults. Think of this as the bank borrowing money in the short term (such as taking in deposits) and lending it for the long term (like making a mortgage loan).  As long as short-term interest rates are lower than long-term interest rates, banks make money on the difference between the two since they “pay” the short-term rate to depositors and “receive” the long-term rate from borrowers.  Keep in mind that this cycle repeats itself: The borrowers spend the money that they borrowed, which ends up in the hands of another person who deposits it with a bank.  That bank then loans out most of these deposits, and the cycle continues.  As this cycle keeps getting repeated through the economy, these deposits are effectively multiplied many times over, allowing the amount of money created (“printed”) by the central bank to grow larger. When the financial system is functioning smoothly, the system is stable because depositors do not need their money all at once. The amount of reserves that need to be held for the demand deposits (i.e. cash in the vault) is a key connection between the sovereign and the bank system.

Central banks are the only entities which can print currency, and while enjoying such rights they also manage the money supply and short term interest rates for the sovereign. In addition to those roles, central banks have a key nexus with the banking system in their role as lenders of last resort during times of financial crisis. When depositors are fearful and demand to be repaid, banks may not have enough cash on hand to meet claims. If banks are properly performing their economic role of transforming short maturity lending (i.e. deposits) into longer dated lending, then the risk of a bank run is an ever present possibility for any bank, no matter how well a bank’s loan portfolio may be performing. Central banking addresses the risk that depositors may not be able to claim their money by providing emergency funding for member banks.

Over the course of monetary history, money has played its role as a medium of exchange and store of value in many forms – metals, shells, arrowheads, even cigarettes. Fiat money is a form of currency that is non-convertible, defined as legal tender, and lacks intrinsic value. Modern fiat money has the property that its value is unmoored from anything tangible: prior to the 1971 Bretton Woods withdrawal, foreigners could redeem a US Dollar via the “gold window” and collect physical gold at a rate of $35/oz.

Governments retain the ability to decide what fiat money can be used for (all debts, public and private) and can declare various contract terms to be illegal (such as gold clauses). Government’s ability to change the rules around the unit of exchange, by fiat, is another manner that tethers banks to their parent sovereign.

Depository Insurance is an additional way that banking systems are conjoined with their governments. There are many ways to set up a depositary insurance system: they can be prefunded, or losses can be mutualized on an as needed basis, and there is debate on what is a rational way to assess costs, and then upon what scope of activities. However, even when limits are fairly low for coverage, during a time of systemic strain, a commercially operated insurance system may be unable to meet all claims, without having a backstop. For example, the FDIC, as a US government chartered corporation, is able to call upon resources that ordinary insurance companies would not be able to summon. In exchange for providing this extraordinary coverage, the FDIC is able to exercise close supervision of certain banking activities. This explains why deposit insurance is another way that banks and sovereigns end up linked, and how a financial virus can flow between the two.

In addition to the controls that the FDIC, and its international analogs, place upon banks, there are other regulatory controls that the sovereign can impose on banks to meet political objectives. Examples might include Community Reinvestment Acts, Anti Money Laundering Laws, Capital Reserve Rules etc. These all end up reducing the pure profit motivations of the banks and blur the difference between a commercial bank, and a “policy” bank such as the GSE’s. The ability of the sovereign to impose/change these requirements, perhaps arbitrarily and capriciously, and often for its own convenience is another aspect of the interconnection between banks and the sovereign. For example, when FannieMae and FreddieMac needed to shore up their capital during the beginning stages of the financial crisis, regulators assigned a highly attractive risk weighting to their junior securities for any US bank that held them for regulatory capital.  Many banks gorged themselves on these since the preferreds delivered higher current income than other comparable zero risk weighted assets; of course in the fullness of time those banks took massive capital losses. Remember that these regulatory levers extend beyond the narrow definition of “banks” and cover the entire financial system: insurance companies and pension funds can just as easily be directed to hold more government bonds by a shaky sovereign having trouble financing a deficit.

After reviewing all of the above, I hope this briefly explains why I consider a bank’s risk profile to be highly intertwined with its parent sovereign’s risk.  Sovereigns are the ultimate backstop for the banking system while banking systems are important ongoing financiers of government borrowings. There is a long history of their mutual problems ending up contaminating each other, so taking an approach that the two are truly independent is unwarranted.