The Coming Financial Crisis: All the Banks are acting as One — What this Means
Wealth, Centralization and Risk.
Once upon a time, there were people and there was nature. One had to make provisions for food, shelter, necessities and luxuries — either oneself or via one’s social influence over others, e.g. family members. The measure of wealth corresponded to the degree of control one had over their circumstances, their surroundings and their property.
There was also then a natural limit or ceiling to one’s wealth — there’s only so much food, shelter or property one could personally accumulate and there’s only so many family members or friends one could reliably trust over the course of a lifetime. Trust is key here, because it allows one to scale beyond personal or familial limits.
If one can (a) trust that their property (food, home, possessions etc) is protected under law, and (b) trust the reliability and efficiency of law enforcement, then one can free oneself from the burden of securing, defending and protecting one’s property. However, this centralization of trust also introduces additional risk — a systemic risk of failure. A decentralized world is devoid of this risk but it is also more inefficient because each person (or agent) has to devote a portion of their time, effort, energy and wealth in performing the redundant task of securing, protecting and defending their property.
Money (or Currency) is not the True Measure of Wealth: What is?
The proposition here is that the true measure of one’s wealth, even today, is proportional to the degree of control one has over their circumstances, their future, their surroundings (and consequently, their property). No matter what measure of wealth you pick, if you do a true valuation analysis of all the assets, liabilities and property that one holds, you would arrive at this true measure of one’s wealth — you must be careful to include everything in your valuation analysis though, including things like brand value, social influence, ability to bypass (objectionable) laws and societal status because these are soft assets that can be turned into performing assets (i.e. cash flow) or sold to an interested party for a fair value.
What this means is that the net worth number of a person denominated in a currency is not a reliable indicator of their wealth, because (a) traditional valuation measures do not include these soft assets, and (b) the monetary value of an asset may be inflated beyond the true liquidation value of that asset — i.e. you may not be able to sell 100% of your property to obtain the amount of money that you value it at, even though you’ve done your valuation correctly based on the marginal price of your property on the market (e.g. a single stock of AMZN is priced at about $3250 as of 5/28 but that does not mean a majority shareholder of AMZN would be able to sell 100% of their holdings in the market at that price). As a trivial example and a fun thought experiment, what this means is that a rich businessman’s mistress who has his ear may be wealthier than both — the businessman and his wife.
In fact a smart play to grow one’s wealth without also becoming a target of the masses is to minimize one’s net worth and currency-denominated property, and maximize other forms of control over one’s surroundings and one’s future. Then, you see, one can amass massive wealth along with the ability to appear unprosperous, which is a powerful asset in and of itself.
When trust in a currency declines, because for example you can no longer obtain certain things or services easily with the currency (either due to regulations or bureaucracy or something else) but you can do so via other means — then the popularity and adoption of these other means of wealth accumulation begins to grow exponentially. If you are the favorite tutor of the child of a powerful government minister, how would you go about doing a valuation analysis of that connection?
What does this have to do with the repo market, banks and the Fed? It’s the degree of control over your deposits, securities, loans and holdings. As we shall see, the more control a bank has over your property, the wealthier they are — even though their balance sheet may not fully reflect it.
The Banks and Their Puppet Master
Since the financial crisis of 2008, regulators were pushed into consolidating the banking industry to “save” the system. The large commercial banks were declared too big to fail, and emerged as key to holding the financial system together. Today, they are drowning in cash from repeated government stimulus programs, Bank of America and JP Morgan Chase in particular. Notice why I say “drowning” and not “awash” in cash — because cash deposits are liabilities, not assets, on the bank’s balance sheet.
The banks are left with extremely limited means to generate income, because arbitraging the yield curve is no longer lucrative at a near zero interest rate. The commercial banks have now resorted to engage in zero-percent-interest overnight-loans with the Federal Reserve, referred to as Overnight Reverse Repurchase Agreements, where the Fed loans them over $400B worth of Treasury securities for cash to alleviate the pressure from all this cash on a nightly basis.
This is the opposite of the problem leading into the financial crisis of 08'. We then had a global dollar shortage as interest rates reset higher and people were unable to maintain their monthly payments once the Fed engaged in a long period of tightening financial conditions. Without enough money to pay on all debts, consumers began skipping payments, fueling the largest financial crisis since the Great Depression of 1929. Today also we have a similar shortage of dollars due to the pandemic and people losing their jobs; but unlike before, the banking system is now drowning in a flood of customer cash (only about a quarter of stimulus checks are being actually spent). The velocity of money supply is dropping while cash deposits, which are liabilities on the bank’s balance-sheet, are skyrocketing.
The Quantitative Easing program seemed like a solution, and the Fed forced the commercial banks to create trillions of dollars in excess reserves. Yet each night they’re borrowing over $400B of treasury securities from the Fed since they have too much money on deposit and a lack of high quality collateral to back it with. If people decided to make a run for their dollars, the banks face a very real risk of implosion. One of the problems with quantitative easing is that the bank reserves (which are created by the Fed and in turn are swapped with the commercial banks in exchange for customer deposits) are locked into a regulatory trap and cannot leave the financial system — the banks refuse to lend against it. What use is additional cash when it’s not fungible and free to be transact with? The Treasury has chosen for now to not issue any additional Treasury securities to the banks and instead let the Fed deal with the problem via nightly reverse repurchase agreements.
Most of the government stimulus is being deposited at Bank of America and JP Morgan Chase. As their balance sheets grow (recall that customer deposits are liabilities of the bank), the banking regulations punish them with additional surcharges and limitations. Citibank is not a large player in the retail banking space and has not received much stimulus money. Wells Fargo is limited in how much it can grow its balance sheet since they’ve been banned from asset growth by the former Fed chair Janet Yellen. We don’t know if and when the Fed will release Wells Fargo from its asset ban but there will be growing pressure in favor of it. If released, they have the capacity to purchase over $500B in treasury securities to relieve pressure from the two big banks — this would put massive downward pressure on treasury yields and inflate asset prices further.
The more the Fed gets involved with the operations of the other commercial banks, the more we have a dependence on centralization (recall from first paragraph above). Each type of such dependence increases risk of systemic failure by a magnitude larger than the last. Moreover, QE and the cash reserves at the Fed don’t mean much on the balance sheet of the banks if the cash is not fungible and free to be spent as per market demands — the valuation of those asset classes thus becomes highly suspect because they don’t reflect the degree of control that another equivalent dollar-denominated asset would imply. When asset valuations become suspect, the trust in the balance sheet drops, and along with it the risk-adjusted models that govern the financial system and the regulations.
What does this imply? Recall that in this context, wealth is roughly the degree of control over circumstances of interest. Who has the highest degree of control over the highest quality (i.e. least risky) assets in the system? Who controls the limitations around banks’ balance sheets and what can or cannot be done with the dollars held in the reserve? What incentive system governs the mechanism of change on those instruments? How do we do a valuation analysis of it? Another financial crisis could be building in the financial system, and the answers to those questions are crucial in the understanding of how it might unfold.
