Tuesday, April 14, 2009

Think investing in banks is dangerous? Time for a reality check

With a few exceptions, buying bank shares is currently associated with buffoonery in the west after the banks brought us the credit crunch and deepest recession since 19twendia waru (the year we sold potatoes). With hindsight, what has happened in the last 18months should not have come as much of a surprise. That banks don't fail more often is a miracle given the role they play in economies. Banks in essence bear an economy's risk. And because, of this owning a bank's share is a handy way of keeping tabs on an economy's direction.

A conventional bank borrows for short-term and lends for the long-term. When you deposit money in the bank or your employer/contractor pays your salary into your account , a large proportion of it will have left the account by the end of the month. Now a bank working on the old assumption that only 10% of its account holders will access their deposits on daily basis, lends the other 90%. It can lend to credit card holders thus matching monthly spending patterns. More importantly for the economy, it can lend for much longer periods than a month to house buyers, businesses and even to govas. This phenomena of taking short-term deposits and using the same to lend long-term is known as maturity mismatch or transformation.

Even if banks didn't do anything but be conventional, this would make them dangerous and risky.

No comments: