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Time's up for small banks

The SVB collapse is just one of many signs that time is up for small banks.

In the past fortnight we have enjoyed the spectacle of another bank run. The word ‘enjoyed’ may not seem appropriate, but for the most part central banks have stepped in and saved depositors: even those whose deposits were above the threshold for protection by national deposit insurance schemes.

In Europe, a larger beast has been ensnared by the liquidity implosion. Swiss Banking giant, Credit Suisse, has reached terms for a merger or takeover by its rival, UBS, after it faced liquidity problems of its own. However, we will grapple with the travails of CS and the controversial (in that it is leading to litigation) action of the Swiss government elsewhere.

By contrast to large banks, small banks have always relied on some degree of state support, including in getting them going. The last decade has seen the UK encourage the growth of smaller ‘Challenger Banks’ to create more competition on the high street.

What we find is that historically banking (and perhaps other sectors too) converges to an oligopoly quite quickly, and the state repeatedly plays the role of a caretaker. Creating space for new banks when needed, perhaps even breaking up large banks from time-to-time. However, the trend is repeatedly for crisis to arrive, and larger banks absorb the smaller banks, and the cycle continues.

Why do smaller banks always seem to be under such potentially terminal pressure? Our focus is on small and medium sized banks, and exploring whether they are a species on the cusp of extinction.

A very needy sector

Over the decades smaller banks have become more and more reliant on various forms of state aid.

On a global level, the latest evolution of Basel capital rules, allow smaller banks to hold less capital than their larger peers, Systemically Important Financial Institutions (SIFI) or ‘too big to fail’ banks.

In the most recent ‘run’ on small banks, the Fed used the bank deposit insurance scheme to rescue depositors above the USD 250,000 threshold that was eligible for protection. And so we witnessed yet another state intervention, albeit by a different route.

At the end of almost every banking crisis, with the 2008 episode being no different, the bad loans of smaller banks are syphoned off into state owned ‘bad asset bank’, to give the smaller banks a clean start. And of course there is nothing new in the collapse of smaller banks. The number of banks in the US has been declining from around 14,000 in the 50s to 4,000.

So why does this sector suffer so many failures so often and so require state intervention?

Structural challenges

To understand the raison d’etre of small banks, it is important to understand modern money itself. Most money in a modern economy, often over 95% depending on the country, is made up of bank deposits. This is often interchangeable with cash (notes and coins), but it is not the same thing. Cash is a liability of the central bank (or the state), where as deposits are a liability of the bank (a private corporation). Cash is risk free, but a deposit can be lost under certain circumstances.

As the Bank of England reminds us, loans create deposits, not the other way around. The classic economics syllabus teaches students that deposits are placed at banks, that are then lent into the economy. Not so.

Rather, when a bank makes a loan, it simultaneously creates two instruments: (a) a loan contract, which is the bank’s asset (as interest from the loan flows to the bank) and (b) a deposit for the borrower is entered into the bank’s ledger (a liability for the bank as it pays interest on the deposit).

A century ago, small banks were essential to this process. They were embedded in local communities, and like the postman or teacher, knew people in the community, and so could extend credit (make loans), and thus create money (deposits). Their unique position in each smaller community gave them a material advantage over the size and scale of the bigger banks of the metropolitan areas.

When understood from this perspective, the problem becomes all too clear.

Searching for a purpose

With credit now assessed by big data and algorithms, through services that can be subscribed to by various lending institutions the need for a small bank that ‘personally knows each customer’ sadly becomes redundant.

Further, the more technology plays a part in the system of credit and so money creation, the more challenging it will be for smaller institutions to keep up.

Finally, with Central Bank Digital Currencies on the horizon, customers will be given even more choice as to how they manage their money: cash, deposits with a bank or digital money (that is a liability of the central bank).

A bleak future

When one reviews each of the banking crisis of the past, there is an entrenched element of overreach. The 2008 crisis was rare in that it impacted major financial institutions. For the most part, crisis impact the smaller banks and wipes out vast swathes of them.

The smaller banks have less access to high quality lending opportunities at attractive rates, and so often their portfolios are made up of the reverse: low quality lending opportunities at unattractive rates.

The German savings banks buying leverage tranches of CDOs (albeit with a good rating on the face of it), was just one example. In the late 80s it was about high yield debt from Leveraged Buyouts. And these are just the high profile failures. Structurally, smaller banks simply have poor access to good assets (high ratings and good yields).

To attempt to gain an advantage they may focus on a niche. SVB focused on the start-up ecosystem, but that approach results in concentration. As rates rose and start ups came under pressure (as the bootstrapping model of refinancing their capital structure would be strained), SVB would have a disproportionate amount of those types of loans on its books. It didn’t help that when SVB endured a failed share issuance, word got out in the small Silicon Valley community and all the depositors rushed for the door at once (i.e. a bank run).

CBDCs pose a new challenge. Previously, access to central bank money for non-banks was restricted to cash (terribly inconvenient form of money: consider what portion of your savings are in cash). With CBDC’s individuals will have a digital alternative that gives access to central bank money, much like individuals can access their deposits at a bank. We will explore this issue in more detail in future articles. That new choice means low yielding deposits from small banks will no longer be attractive.


Credit and money are changing. Small banks were part of a network of institutions that provided access to loans (and so simultaneously created money), but in the face of the epochal changes to money, it is no surprise that legacy infrastructure like small banks will be set aside.

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