It's a Wonderful Life (bank run scene)

What can we learn about banking?

Today’s inaugural post is particularly long; much longer than the vast majority of posts that you will find in my newsletter. I am repeating here for the benefit of new subscribers a summary of what we cover in the first day of my undergraduate Financial Services Industry course at W&M. So if in reading this post you feel like you are back in school, there is a good reason for this. But don’t despair; most of my posts will be much shorter, more entertaining and more geared to current events in the financial news. So please stick with me; I promise you will find it worthwhile.

Every Christmas I watch the film “It’s a Wonderful Life”, which restores my faith in humanity. But my favorite part of the film is not the salvation of the suicidal George Bailey by his bumbling guardian angel Clarence or the wonderful community rendition of Auld Lang Syne at the end. It is of course the bank run scene, where George and Mary Bailey save the old Bailey Building & Loan with an emergency injection of cash they had saved up for their honeymoon. What else would you expect from a banker turned finance professor?

If you don’t already know the film you should definitely watch it, if not now then next Christmas. And if you do know the film but don’t recall much about the bank run scene, you can watch it again here:

But it’s not Christmas time and I’m not a film critic, so why am I writing about this? Because I think there is a lot to be learned about the business of banking from just these six minutes or so of Hollywood schmaltz. So, let me ask (and answer) a few questions of educational import: What happened here? Why did it happen? Why should we care? And, what can we learn?

What happened here? Obviously there was a “run” on the Bailey Building & Loan, with depositors all rushing to withdraw their savings from the bank at the same time. The bank did not have enough cash on hand to repay all of these unexpected depositor withdrawal demands, so Uncle Billy panicked and shut the bank’s doors which only made the situation worse. Had George and Mary Bailey not come up with emergency funding, the BB&L would have been out of business and its depositors left in the lurch. Banks can be very fragile institutions, and confidence earned over decades can be lost very quickly, as history has demonstrated time and time again.

Why did this happen? We don’t really know exactly what triggered the run on the BB&L, but it seems that that the other bank in town had already closed (for reasons that are also not clear) and this cross-town bank failure may be what prompted the panic among the BB&L depositors. Keep in mind that this portion of the film is set in small town New York during the 1930’s, a period during which a large number (thousands) of banks failed across the US, particularly in rural areas and small towns. So bank runs were not an unusual thing, and depositors knew that if you didn’t get your money out quickly you might lose it all. Note here that the action of the BB&L depositors collectively may seem irrational to us, but viewed individually their behavior was not at all irrational. The risk-return calculus to individual savers was highly skewed (lots of risk for little return) and they probably did the right thing in trying to pull out their cash or even to sell their shares (deposits) for fifty cents on the dollar, offered by Mr. Potter (who also took over the cross-town bank).

Why should we care? We should (and do) care about bank runs because bank failures have the potential to create large social and economic complications that impact the broader community. (Economists would call these effects “externalities”.) We all lose when banks fail; the financial damage is not limited to the banks’ depositors and shareholders. Think about a financial system in which individuals and businesses cannot entrust their savings to a sound bank or similar financial institution for fear of losing it all at any moment. How would this impact one’s willingness to save, invest and spend? Who would make loans to business and individuals? Who would host the local soccer team? What would be the impact, financial and otherwise, on our economy and our communities?

If you’re not convinced by my arguments, reflect for a moment on the economic, social and political impact of the massive wave of bank failures in the 1930s (not just in the US, but globally). And think also about the economic carnage (tens of millions of lost jobs and homes) that followed the narrowly averted collapse of the US and global banking system in 2008, also caused by a massive “run” on the banks and other financial institutions. Suffice it to say that we should and do care about managing the risk of bank failures, and banks are heavily regulated institutions as a result.

What can we learn? This simple film clip has a lot to teach us about the basic banking business model and how banks (and regulators) go about managing and mitigating the risks inherent to the banking business. The basic business model of a depository lending bank like the BB&L is simple: Take Deposits, Make Loans and Capture NIM (Net Interest Margin). It used to be said that bankers operated on the 3-6-3 model: Take deposits at 3%, make loans at 6% and be on the golf course by 3pm. Well life isn’t that easy for bankers anymore, which is bad news for bankers but good news for those who can now get mid-week tee times.

There are three principal risks to the basic banking (depository lending) model which I’d like to highlight here: (1) credit risk—the risk of losses to the bank resulting from customers who default on their loans; (2) interest rate risk—the risk of reduced net interest income resulting from changes in the level of interest rates paid on funding sources and earned on loans and investment securities; and (3) liquidity risk—the risk of having insufficient cash (or access to cash) needed to meet unexpected funding withdrawals (in extreme form, a bank run). Of course there is also a fourth risk—insolvency (negative equity)—which can be triggered by any or all of the first three risks.

For today’s purposes, let’s focus on the third risk, liquidity risk. We have seen how this risk manifested itself at the BB&L, and those of you who lived through the events of 2008 (or who watched or read “Too Big to Fail”) will also know how this happened more recently to a wide range of banks and other financial institutions in the US and abroad. Liquidity risk is of particular concern to banks because bank liabilities (deposits and other funding sources) tend to be short-term and hence “liquid”, whereas bank assets (loans especially) tend to be longer-term and hence “illiquid” (particularly in the days before the advent of active secondary trading markets in loans). When Lehman Brothers failed in 2008, it had ca $700bn of assets much of which had become highly illiquid (unmarketable) during the financial crisis and it had $250bn of overnight repo funding which it had to roll every single trading day. Lehman was probably insolvent at the time it failed, but the main reason it failed was because of liquidity risk: the capital markets refused to roll over its short-term funding. No funding, no business. Puff Lehman was gone. (The same thing happened at Bear Stearns, and other institutions.)

So how do banks and regulators manage and mitigate this inherent liquidity risk? There are several ways, all of which are effective but they all have costs (sometimes very large costs). First the banks can hold more cash in reserve; but this reduces the amount of funding available for making high margin loans (and reduces the amount of credit in the economy). Second the bank can fund itself with time deposits or other forms of longer-term borrowing, rather than short-term funding, but this too will reduce income as demand deposits and short-term funding sources tend to cost the bank less than other forms of borrowing. And from a regulatory perspective, we can mitigate the risk of systemic bank runs by raising reserve requirements (the amount of cash banks must hold in reserve, relative to demand or transactional deposits) and/or through a system of deposit insurance (funded publicly and/or by the banking system). Our current form of deposit insurance began in the 1930s, in response to widespread banking failures, but other forms of deposit insurance have been around much longer than this, with mixed results.

But the main way in which we mitigate liquidity risk in the banking system today is by having a public (governmental) “lender of last resort”, which in the US is the Fed. In 2008, the Fed and other central banks flooded the banking system with liquidity, and extended emergency funding to many non-regulated financial institutions (like investment banks). Were it not for the Fed and other central banks acting in their role as "lender of last resort”, we might well not have an economy (let alone a banking system) today. This is serious stuff, and not just in Hollywood films.

Hopefully, you now understand why I use this film clip on the first day of my Financial Services class, when we begin to study banks. The film is enjoyable, entertaining and educational. If all you know about banking is what you learned from this film clip (or this note), you are ahead of 90% of the US public and 95% of our elected representatives. So well done. Keep these lessons in mind as we continue to explore the banking industry in future posts.

Regards, PT (Professor Tack)