3.2.2 Why banks are special

Banks are ‘special’ in the sense that they are different from non-financial firms. In the first place, banks are characterised by a high leverage. A high leverage means that the amount of equity is very low compared to the amount of debt. It has been observed that the banking sector is the sector with the highest leverage.1 In this respect, banks are different from other firms. In the second place, banks have a large balance sheet compared to non-financial firms. It has been remarked that “the size of the largest banks dwarfs that of the largest non- bank business”.2

But most importantly, banks are more interlinked and more interconnected than non-financial firms. This interconnectedness may create systemic risk. Systemic risk is sometimes related to banks that are too-big-to-fail, too-complexto-fail or too-interconnected-to-fail. It can be argued that in a crisis situation, every bank has systemic relevance.3 The failure of one bank may have dramatic repercussion for other banks. In other words: bank failure is contagious. This goes by many names: contagion effect4, domino-effect5, spill-over effect or systemic risk. Thus, the failure of a bank can have a negative effect on financial stability. Why is bank failure so contagious? This is due to the following reasons.6

There are direct linkages between banks. This is because banks lend to each other. In other words: banks hold claims on each other.7 If a bank fails and goes into insolvency, then it is no longer able to honour its claims. Consequently, the banks that have claims on the failing bank have to write down their claims.8 This is a form of direct contagion.

Another connection between banks is related to the fact that banks usually hold similar assets.

If a troubled bank needs funding – and is unable to get enough wholesale funds – it has to sell assets quickly. This may lead to a fall in asset prices. This might depress the value of similar assets held by other banks. This could turn into a negative spiral.9

The failure of one bank may trigger a loss of confidence in other banks. Indeed, as a result of the failure of a bank, investors might become worried about the viability of other banks, either because they perceive the other banks as similar to the failed bank or because they expect that the other banks will be affected through the direct linkages with the failed bank.10 Thus, the failure of one bank may trigger a loss of confidence in other banks.11

Such a loss of confidence can have dramatic repercussions. This is because confidence is crucial to the banking sector. Banks are dependent on confidence; this is their ‘Achilles heel’.12 Because of their business model (lending long and borrowing short), access to short-term funding is crucial to banks. This makes it highly important for a bank to retain the confidence of its creditors.13

The most extreme form of a loss of confidence in a bank is a bank run by its depositors. However, because of deposit guarantee schemes, bank runs by depositors are not very likely to happen.14 Nonetheless, deposit guarantee schemes do not mitigate the risk of a ‘modern’ bank run. In that regard, it should be noted that banks are sometimes dependent on the money market and interbank market.15 The funds obtained on these markets are not insured by deposit guarantee schemes. Accordingly, when investors on these markets lose confidence in a bank, then they are likely to withdraw their funds.

Because of the essential role of confidence, the fall of one bank can result in the fall of other banks. And even if the failure of one bank does not lead to a complete downfall of other banks, it may still create problems for those other banks. A bank may face higher funding costs: if investors lose confidence in a bank, then they perceive an investment in that bank to be more risky. Subsequently, they would demand a higher return. In other words: the bank faces higher funding costs.16

To conclude, because of the interconnectedness of the banking sector, bank failure may be contagious. This particular feature of the banking sector makes banks ‘special’ (as compared to non-financial firms).