More Banking Panics Are on the Way

After the creation of the FDIC in 1933, it became much more difficult to stir up a major banking crisis. The reason was simple: A key ingredient in the Great Depression and previous banking panics were bank runs by depositors, an issue that was effectively averted by government guarantees.

And yet here we stand today, in the wake of a major financial crisis that was significantly fueled by -- you guessed it -- runs on the banks.

Of course this time it wasn't the classic scene of Average Joe joining a long, jostling line in front of his local bank branch to try and pull out his money. This time around it was major financial institutions losing faith in their peers and yanking the short-term financing that was keeping many major financials afloat.

And if we want to have any hope of battening our system against future meltdowns, we absolutely need to address this issue.

A scary picture
Think those adjustable-rate mortgage loans with their resetting rates are unsettling? What if mortgage financing wasn't even that stable?

Imagine if the homebuying process involved negotiating multiple ultrashort-term lending agreements. Let's say, for example, that you're buying a $200,000 house and you end up borrowing $50,000 from four different lenders. Each is a daily maturing loan that automatically rolls over unless one of the parties decides otherwise.

While this financing might cause more sleepless nights, you might not notice the difference between it and long-term financing as long as you're employed, times are good, and the loans are continuously rolling over.

But what happens when the housing market starts to wobble and you're facing a 20% pay cut? Suddenly your lenders aren't quite as sanguine. Perhaps one decides to pull the lending agreement altogether, requiring you to cough up $50,000. Now.

Nothing new for bankers
Of course, using short-term financing to fund long-term assets is nothing new for traditional banks like BB&T (NYSE: BBT) and PNC Financial (NYSE: PNC).

The most vanilla banks out there bring home the bacon by taking customer deposits and using them to make loans. For the most part, deposit customers are free to withdraw their money any time they want, while the bank's loans can range from a few years to multiple decades.

In other words, the banking system was built on mismatched funding.

This system became particularly dangerous when the economy hit the skids, fear got the best of depositors, and everyone came running to reclaim their money all at once. As noted above, though, the creation of the FDIC has made it unnecessary for most depositors to fret about their accounts. If the bank fails, Uncle Sam will be there to pick up the pieces.

No FDIC for the big boys
Since FDIC insurance only covers up to $250,000, what happens when you have, say, a few hundred million to deposit?

That's exactly the problem that many major money market funds, investment managers, and pension funds run into. When they have money that's uninvested, they'd like to put it somewhere that's safe and offers some sort of return.

Enter the repo market.

Repurchase agreements are typically very-short-term lending agreements (often just one day) between financial institutions. One party lends money to the other in exchange for some interest payment and a slug of assets to act as collateral. It is typically a safe way for lenders to earn interest on excess cash, while for borrowers it's a good way to finance activities with higher yields than what they're paying out in interest.

For many of the financial highfliers, these kinds of short-term agreements had become a primary source of financing in the precrisis days. Here's a comparative look at funding among more traditional banking institutions and folks like Goldman Sachs (NYSE: GS) back in '07.

Source: Company filings and author's calculations.

Companies that rely heavily on funding sources other than deposits and long-term debt run an extremely high risk of having their liquidity lifelines cut. Couple that with high levels of financial leverage and you end up with a pile of tinder soaked in gasoline just waiting for a spark to ignite it.

In all the talk about financial reform and working to prevent future crises very little has been said about doing something about this very real challenge. The next wholesale banking run may not happen tomorrow or even five years from now, but unless it is dealt with, it's not a matter of if, but when it happens again.

Now it's your turn to weigh in. Scroll down to the comments section and share your thoughts on this financial system pressure point.