Public funding of failing banks in the European Union (LBF vol. 19) 2020/2.3.2:2.3.2 Reasons for special prudential treatment of banks

Public funding of failing banks in the European Union (LBF vol. 19) 2020/2.3.2

2.3.2 Reasons for special prudential treatment of banks

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The balance sheet of a bank reveals the reasons for the special prudential treatment of banks. These reasons include the maturity mismatch, the high leverage of a bank’s business model and the possibility to quickly change the volume of banking activities.1

Maturity mismatch: Banks collect demandable deposits and raise funds in the short-term capital markets and invest them in long-term assets. This maturity mismatch allows them to offer risk sharing to depositors, but also exposes them to the risk of bank runs. Bank runs can involve the withdrawal of funds by depositors (retail runs) or the drying up of liquidity in the short-term capital markets (wholesale runs).2

High leverage of business model: The main activity on the asset side of a balance sheet of a bank involves lending activities. Those activities are financed through a limited amount of equity supplemented by funds provided by creditors. No other sector is characterized by such a high leverage.3

Possibility to quickly change volume: Banks can quickly expand (and contract) their balance sheet and hence the volume of their business. No other sector has grown as rapidly and as explosively as the banking sector in the last decades.4

In particular, the reliance of banks on short-term wholesale funding to finance the expansion of their balance sheets, together with excessive leverage have been highlighted as key factors in the buildup of systemic risks that underlie the GFC.5

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