However, this model’s weakness was its susceptibility to “bank runs” on deposits. Whenever depositors believed that banks were in deep trouble, they would panic and “run” to the banks to withdraw their deposits. The runs would often even affect healthy institutions, resulting in cascades of insolvencies, as banks sold assets at “fire sale” prices to meet the deposit withdrawals. This problem was largely resolved by the establishment of the Federal Deposit Insurance Company (FDIC) in 1933. Should banks fail, depositors are now insured against losses by the FDIC up to $250,000 per account.
Beginning in the 1970s, banks began to modify their traditional funding model by expanding their funding sources to include the wholesale markets, as shown in Figure 1. More specifically, banks began relying more heavily on issuing short and long-term debt to other financial institutions. This enabled banks to grow larger without relying as heavily on retail deposits. Furthermore, it enabled banks to leverage to a greater degree, and thereby potentially increase their return on equity.
Wholesale funding instruments, also known as non-core or non-deposit liabilities, include repurchase agreements, foreign currency debt, commercial paper, large-denomination certificates of deposits (CDs), federal funds, and brokered deposits. The purchasers of such instruments are large institutions such as hedge funds, private equity firms, insurance companies, ultra-high net worth individuals, and corporations.
Figure 1 & 2
Source: Federal Deposit Insurance Corporation.
Since wholesale funds in the form of debt are generally not insured like retail deposits, large institutions in the wholesale market attempt to achieve a comparable degree of security and safety by putting their money into high-quality collateral, such as mortgage-backed securities and government treasuries.
A problem that arises with this newer funding model is that to the extent a bank cannot roll over its short-term debt, it may have to sell off assets if it cannot obtain additional deposits or issue additional equity. In short, if purchasers of short-term debt believe that banks are in deep trouble or collateral is impaired, they may decide to “run” away from such debt, which creates a problem somewhat similar to that which existed before the establishment of the FDIC’s deposit insurance scheme.
Ironically, this means that the modern banking system still faces runs, but no longer on just retail deposits. Instead, as shown in the financial crisis that fully emerged in September 2008, banks are now vulnerable to runs by participants in the wholesale funding market. In 2008, the world watched as the wholesale market seized up, and banks could not rely upon this market funding. Banks’ ability to roll over their debt and uninsured liabilities disappeared overnight along with their ability to use repurchase agreements. As a result, the government created the Troubled Asset Relief Program (TARP) to provide funding to banks, and the Federal Reserve engaged in three quantitative easing programs.
In the course of the evolution of the banking system, the government solved one problem early on, but a new one arose in its place. Since the modern banking model is now more dependent upon wholesale funding, high-quality collateral will likely be instrumental to finding a solution that both emulates the earlier solution provided by a federal deposit insurance system, and helps prevent runs on the wholesale market. Whatever steps regulators take next will have landmark consequences for preventing or reducing the severity of future financial crises, just as the FDIC’s introduction of retail deposit insurance did.
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