The terminal disease affecting banking

Es que se estan acabando, dice el FT

There’s no doubt, for example, that banks have held the top spot in credit creation for decades, if not centuries. Yet, there’s equally little doubt that banks have spent most of the last quarter of a century branching out into ever more exotic services and roles.

So why has that been?

In order to answer that it’s first important to understand what traditionally drives bank profitability.

As Steve Randy Waldman at Interfluidity points out it’s not, contrary to popular belief, their ability to create credit. Indeed, as we have also argued, any reputable institution or individual has the ability to do that. No, in Waldman’s opinion the power of banks actually lies in their more unique ability “to issue liabilities that are widely accepted as near-perfect substitutes for whatever trades as money despite being highly levered.”

So it’s really all about guarantees, and more specifically faith in those guarantees. You give money to a bank on deposit because you trust that it will remain a money-like instrument even though it’s earning you some interest.

Indeed, you get a return without having to compromise the liquidity profile of your holding. You get something seemingly out of nothing.

The rise of shadow banking is thus closely connected to investors becoming ever more satisfied that non-banks can perform a similar role. That, combined with the fact that these shadow banks can also guarantee liquidity without sacrificing basic returns, of course suddenly makes them competitors with banks.