September 12, 2017 Investing 0 comment

Anti-Fragile & the Banking System

Anti-Fragile and the Banking System

Nassim Nicholas Taleb is an author and investor that uses his unique background to help create his view of systems. He is the author of at least four very popular books with the Black Swan being his most well know. I want to highlight how the concepts in one of his books is applied to today’s markets.

In the book Anti-Fragile, Nassim examines the idea that a system that becomes stronger from chaos is more robust than a system that is weakened by chaos. The banking system is an example of a system that is more fragile the greater the level of chaos that occurs in our economy. The banking system employs a great amount of leverage in it’s operations. It must do this to create a significant enough level of profit. The leverage is both the source of the profit and the source of most bank’s problems.

If a bank would target a 10% return then it must leverage it’s balance sheet to accomplish this. A bank earns income on the spread between it’s assets (loans) and liabilities(deposits). If that spread is 1%, then it must leverage the balance sheet 10 times in order to earn a 10% return. This mean the bank would have assets that are equal to 10 times it’s capital base.

Bank X

Bank Equity       +         Liabilities         =     Assets

$1MM                               $9MM                  $10MM

Return on Equity (ROE) –  annual return divided by the equity

$10MM * 1.0% = $100,000 / $1MM  = 10%

Two major problems arise from this type of business model. The first is that the banks liabilities are typically very short term (deposits or other borrowings with daily liquidity) and it’s assets are typically long term (term loans with multi-year payment schedules). This is referred to as a duration mismatch. Bankers work very hard to manage this mismatch and are successful the vast majority of the time.  The second issue is the volatility in the price of the assets. The change in the value of the assets is magnified by the amount of leverage employed. In the above example, a 1% change in the value of the assets is equal to a 10% change in the value of the equity. A 10% decline in the value of the assets would completely wipe out the equity. Banks do not like chaos.

Legislation has been passed that on the surface would seem to stabilize the banking system. The Federal Deposit Insurance Corporation (FDIC) is an entity most people are familiar with if they have a bank account. This Insurance program is designed to cover depositors in the event their bank would fail. This gives depositors a comfort level that helps minimize the volatility of the deposit base and allows the banks to safely leverage their balance sheet. If deposits were not insured, then depositors would tend to move their money if they thought their bank was in trouble. I have seen this first hand with depositor behavior on deposits above the insurance limit.

Why is the FDIC program a bad thing? The negative consequence of having the insurance program is that banks struggle to differentiate themselves from one another. The quality and strength of the bank matter little compared to the rate they are willing to pay on their deposits. Banks know this and therefore do what they can to be competitive. The bank making the riskiest loans and paying the highest rate sets the standard. This eventually leads to all banks making riskier loans so they may pay higher rates. If enough banks having been forced to make enough risky loans, the next economic downturn runs the risk of becoming a banking crisis. There have been two major banking events in the US in the last 30 years.

I would position the trade off this way. If FDIC insurance did not exist then banks would be forced to compete on the safety of their deposits in addition to the rate they pay on deposits. This would incentive depositors to pay attention to where they placed their savings. It would also allow banks to find better ways to differentiate themselves. A balance would eventually be found between safety and return. As it stands now, FDIC insurance tends to concentrate deposits in the hands of the riskiest banks at the expense of the safest banks. This incentive would increase the risk in the bank population over time as deposits chased yield without regard to safety.

I will discuss a system that gets stronger from chaos in a future post.