Crisis Background
In order to understand the credit crisis it is important to understand certain fundamental banking principles. A bank is basically a trading company. The only difference is that it trades in money. It buys money from those that have too much (customer savings, money market) and lends it to those that have to little (companies, consumer loans). The price which a bank pays is interest (for instance the interest on your savings account). The price which a bank receives is also interest (which you pay if you lend money). A bank cannot loan somebody any money which they did not first lend themselves (or money is available as equity, but ignore this for now). In other words a bank cannot sell what it has not bought.
If people are talking about funding they are talking about the need for banks to buy money, before they can sell it again. Consider the following example. A bank has two customers (customer A and B) with a deposit holding €100,- each. There is one customer (customer C) lending €200,- from the bank. In this example customers A and B with the deposits provide the bank with funding, which the bank than uses to loan to customer C. If a new customer (D) requests a loan of €200,- from the bank, a problem arises. The bank will have to attract additional funding. In other words it will have to find somebody prepared to lend €200,- to the bank. This could for instance be additional savings accounts from customers. From a banking perspective the funding is a liability (right side of a balance sheet) because it is a debt which it will have to repay. The €200,- loan to customer C is an asset because the customer will have to repay the bank. On a balance sheet this looks as follows:
| Assets | Liabilities | ||||||||
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| Total Assets: €200,- | Total Liabilities: €200,- |
By buying and selling money, banks fulfill an important role in society. They are an intermediate between those people who have more than they need and those that want to expand their business. But banks also have a more subtle role in society with which they also earn their money (or some of it anyway). Banks provide liquidity. Let me first give the formal definition of liquidity: The ability to fulfill short term obligations.
In other words the ability to pay those people who you have to pay, in the short term (say the coming year). A company has a good liquidity if its liquid assets are worth more than its short term liabilities. This means that a company is able to generate more money (by selling liquid assets in the short run) than it needs (for paying its short term liabilities). This also means that some of the liquid assets need to be paid with long term loans. The balance sheet shown below gives a representation of a company with a good liquidity.
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As the figure shows, the liquidity can be improved by attracting more long term capital (equity or long term loans) to finance short term assets. This gives a company a larger buffer for paying its short term obligations.
Banks provide liquidity to normal companies (non banks) by purposely destroying their own. Let us return to our example. Assume customer C has lend the €200,- for ten years (the maturity is ten years). This means that the bank will not receive the money back for ten years. In general, banks will make sure that their funding has a shorter maturity. Let us assume that customer A and B both have put their money in a deposit with a five year maturity. In other words the bank will need to repay customer A and B in five years. To recap, a bank will have to repay customer A and B in five years and will receive money in ten years. In liquidity terms this is horrible. This bank will not be able to pay their short term obligations (to customer A and B) because it has no cash flow (from customer C) when they have to be paid. For customers who lend money from a bank this is fine. They are able to lend long term money and thus increase their own liquidity (by using the long term money to invest in short term assets).
Banks do not undertake these activities out of the goodness of their harts. It is an important (if not the most important) source of income. In general the interest rate on a short term loan is lower than the interest rates on long term loans. In our example the cost (interest rate) of the deposits (the funding) from customer A and B will be lower than the return on the loan to customer C, thus generating profit. In return for this profit, banks accept a risk. After five years the bank needs to repay customer A and B but has no money to do so. This means that a bank will need to refinance those loans. This means it has to find other customers (or convince the same ones) to put money in a deposit. If nobody is willing to do this, a bank will go broke.