Understanding Bank Fragility: Microprudential Regulation and Bank Balance Sheets, Assignments of Law

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• Our focus today will primarily be on how financial regulation seeks to ensure the microprudential safety and soundness of banks. Notably, however, promoting safety and soundness is generally consistent with the objective of promoting consumer protection: and specifically the protection of a bank’s depositors.

• As a preliminary matter, someone cannot simply open a bank: they need a bank license. This necessitates a legal definition of what constitutes a “bank”. While definitions vary from jurisdiction to jurisdiction, they generally reflect the fact that banks combine (1) deposit-taking and (2) loan making.

• These legal definitions are clearly reflected on the balance sheets of each and every bank. On the left-hand side of the balance sheet are the bank’s liabilities: the promises it has made, and the amounts that it owes, to its depositors and other creditors. The right-hand side of the balance sheet are its assets: in this case loans and reserves (i.e. cash).

• The key to understanding the fragility of bank’s balance sheet is understanding that, by definition, a balance sheet ALWAYS balances. Thus, if a bank’s assets go down, so two must its liabilities (and vice versa).
• This makes the relationship between a bank’s assets and liabilities extremely important. Most importantly, there exists an obvious mismatch between a bank’s deposit liabilities (immediately redeemable at full value) and its assets (which cannot be quickly sold, and often not for full value). This mismatch is the source of a bank’s fragility.

• After all, absent regulatory intervention, most depositors will be unsecured claimants in the (insolvent) bank. This creates a ‘first come, first served’ type situation where depositors rush to withdraw before the bank is rendered insolvent and is no longer legally entitled to satisfy depositors demands for cash.

• Limited coverage incentivized wholesale depositors to run.
• Relatively low cap meant that a significant percentage of depositors had uninsured deposits.
• Depositor participation (10%) for amounts over 2,000 generated another clear incentive to run.
• And perhaps most importantly, depositors would potentially be required to wait years before getting their money back!