If you study the history of bank failures, one thing stands out: While banks typically get into trouble because of poor credit discipline, their actual failure is generally triggered by illiquidity. Fortunately, banks appear to have learned this lesson -- though we probably have the 2010 Dodd Frank Act to thank for that -- as lenders like Bank of America (NYSE:BAC) and others have taken significant steps over the last few years to reduce liquidity risk.
It's important to keep in mind that banks are nothing more than leveraged funds. They start with a sliver of capital, borrow money from depositors and creditors, and then use the combined proceeds to buy assets. The difference between what they earn on those assets and what they pay to borrow the funds makes up their net revenue -- or, at least, a significant part of it.
Because this model allows you to make money with other peoples' money, it's a thing of beauty when the economy is growing and there are no warning signs on the horizon. But it's much less so when things take a turn for the worse. This follows from the fact that a bank's funding could dry up if creditors lose faith in its ability to repay them, or if they need the money themselves. And if a bank's funding sources dry up, then it may be forced to dispose of assets quickly and at fire-sale prices in order to pay its creditors back.
This is why some funding sources are better than others. Deposits are the best because they are the least likely to flee at the first sign of trouble. Within deposits, moreover, insured consumer deposits are preferable, at least in this respect, to large foreign, corporate, or institutional deposits, which carry a greater threat of flight risk because they often exceed the FDIC's insurance limit.
The second most stable source of funds is long-term debt, as this typically can't be called by creditors until it matures. Finally, the least stable source consists of short-term debt, including overnight loans from other banks as well as funds from the "repo" and/or commercial paper markets. Because these must be rolled over at regular intervals, sometimes even nightly, they give a bank's creditors the option of not doing so.
It should come as no surprise, then, that many of the biggest bank failures in history stemmed from an over-reliance on either short-term credit or on large institutional depositors. This was the reason scores of New York's biggest and most prestigious banks had to suspend withdrawals in the Panic of 1873, during which correspondent banks located throughout the country simultaneously rushed to withdraw their deposits from money center banks after panic broke out on Wall Street. This was also the case a century later, when Continental Illinois became the first too-big-to-fail bank in 1984. It was the case at countless savings and loans during the 1980s. And it's what took down Bear Stearns, Lehman Brothers, and Washington Mutual in the financial crisis of 2008-09.
A corollary to this rule is that one way to measure a bank's susceptibility to failure -- which, as I discuss here, should always be at the forefront of investors, analysts, and bankers' minds -- is to gauge how heavily it relies on short-term credit and institutional deposits as opposed to retail deposits and long-term loans. If a bank relies too heavily on the former, particularly in relation to its illiquid assets, then that's an obvious sign of weakness. If it doesn't, then that's a sign of strength -- though, it's by no means a guarantee that a bank is otherwise prudently managed.
One way to gauge this is simply to look at what percentage of a bank's funds derive from short-term loans as opposed to more stable sources. As you can see in the chart below, for instance, Bank of America gets roughly 16% of its funds from the short-term money market. That's worse than a smaller, simpler bank like U.S. Bancorp, which looks to the money market for only 9% of its liquidity, but it's nevertheless better than, say, Bank of America's former reliance on short-term funds, which came in at 31% in 2005. Indeed, as William Cohen intimates in House of Cards, one of the "dirty little secret[s]" of Wall Street companies prior to the crisis was how much they relied on overnight repo funding to prop up their operations.
A second way to measure this is to compare a bank's funding sources to the liquidity of its assets, and loans in particular, as loans are one of the least liquid types of assets held on a bank's balance sheet. This is the function of the loan-to-deposit ratio, which estimates whether a bank's deposits can singlehandedly fund its loan book. If deposits exceed loans -- though, remember that not all deposits are created equal -- then a bank could theoretically withstand a liquidity run by pruning its securities portfolio or using parts thereof as collateral in exchange for cash. This would protect it from the need to unload loans at fire-sale prices which, in turn, could render the bank insolvent.
Overall, as the chart above illustrates, the bank industry has aggressively reduced its loan-to-deposit ratio since the crisis. In 2006, it was upwards of 96%. Today, it's closer to 70%. It can't be denied that some of this downward trend has to do with the historically low interest rate environment, which reduces the incentive of depositors to alternate out of deposits and into low-yielding securities. But it's also safe to assume that banks have intentionally brought this number down to shore up their balance sheets, and in response to the heightened liquidity requirements of the post-crisis regulatory regime.
Whatever the motivations are behind these trends, one thing is certain: At least from the standpoint of liquidity, the nation's banks have come a long way over the last few years to build a safer and more stable financial system. This doesn't mean we won't have banking crises and liquidity runs in the future, as history speaks clearly on the point that we will. But it does mean that, for the time being anyhow, this is one less thing for bank investors to worry about.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.