Sobering Up To Scarce Liquidity

Banks need to make their funding requirements top priority.

The populations of most western countries had negative savings rates before 2007, spending more than they earned, and borrowing to cover the difference. Most western banks had loan-to-deposit ratios in excess of two to one.

But this did not increase their funding costs because wholesale funds were extraordinarily abundant. Banks could be leveraged 35 to one and still pay almost no “risk premium” in the wholesale markets thanks, in part, to the massive growth of savings in emerging markets and to the perception (accurate, as it turned out) that even wholesale bank debt enjoyed government guarantees.

This almost free leverage allowed many banks to deliver returns on equity above 20 percent. So, equity capital was also in easy supply. In short, when it came to the principal resource of banks—namely, debt and equity capital—the basic economic problem of scarcity seemed to have been abolished.

Of course, this was an illusion. And, like most illusions, it was dangerous. It removed banks’ incentive to be astute managers of their financial resources. A business gains no advantage over its competitors by being better at managing a resource that is free, such as the air we breathe. While debt and equity capital flowed cheaply to all banks equally, regardless of the risks they were taking, they became careless managers of it.

We all know what happened next.

Sobering Up To Scarce Liquidity