A Comparison Between Traditional Banking and Market Based Finance

I've been working on a paper using stylised balance sheets to look at the interaction between traditional banking and market-based finance.  The aim is to examine the reasons for shifts between these two intermediation models before and during the crisis and the implications for liquidity and solvency across the sector.  In this post, I just want to give a brief overview of the differences between the two techniques.

The diagram shows some simplified balance sheets.  These are not necessarily supposed to represent distinct entities, so much as different business models.

The assets of traditional banking consist of a loan portfolio and a holding of high quality liquid assets (HQLA).  The liabilities will be short term unsecured deposits with the balance forming capital (there will be other borrowings of a longer term nature, but we can ignore those here).

 The loan portfolio will be long dated assets which will generally be fairly illiquid, in that it is difficult to sell them at short notice for a price close to balance sheet valuation.  Given the short term nature of its deposit liabilities, the traditional bank is therefore running a maturity mismatch risk.

To deal with this mismatch, the bank maintains a holding of HQLA.  This might consist primarily of government securities, but central bank reserves would also be included in this.  In the event that it faced deposit withdrawals in excess of the rate of run-off on its loans, the bank would hope to cover this out of its HQLA holding.

The traditional bank is therefore running a kind of liquidity insurance.  It is offering liquidity to all of its depositors but covering this with a much smaller quantity of liquid assets.  Its risk is that more depositors wish to withdraw their deposits at once than it can cover out of liquid assets.

With market based finance the assets are all marketable instruments.  I have illustrated this here as securitised loans.  The underlying loans may be similar to those held as illiquid assets on the traditional bank's balance sheet.  The process of securitisation transforms these into a standardised tradeable instrument.  This means they can be bought and sold much more easily.  With sufficient market depth, there will be a continual market price for these securities and a holder will expect to be able to sell at close to that price.

Having liquid securities as its assets allows an entity using market-based finance to fund itself using secured financing, for example repo.  The repo funding provided by investors is effectively secured by underlying assets (the securitised loans).  The value of the security provided is slightly higher than the amount of funding and, critically, is adjusted every day for market movement.  This is only possible because the collateral is in the form of marketable securities with a transparent market price.  The level of additional security provided therefore only needs to cover possible day-to-day price movement.

In the market based finance model, all of the assets are used as collateral[1].  There is no pool of unencumbered liquid assets like the HQLA held by the traditional bank.  However, no such pool is needed, because the market based finance model is providing liquidity in a different way.  Rather than rely on a type of insurance as in traditional banking, the liquidity transformation relies on the marketability of the underlying assets.  Whereas a traditional bank would dip into its pool of unencumbered liquid assets to deal with a high level of withdrawals of its funding, an entity using market based finance would simply look to sell down its regular asset base.

Both business models face liquidity risks, but they manifest themselves differently.  The liquidity risk in traditional banking is that the HQLA holding is insufficient to cover withdrawals.  The liquidity risk in market based finance is that the liquidity of the assets fails.  For both models, the robustness of their liquidity strategies may change.

A depositor with a traditional bank is taking credit risk on the bank.  They do not know the intricate details of bank's balance sheet, so they are relying on the skills of the bank's management in making good business decisions.  They will however draw comfort from the level of capital which provides a cushion against loan losses.

A provider of finance in the form of secured funding takes much less risk on the borrower itself, relying instead on the collateral provided.  Some degree of over-collateralisation is needed to meet rating requirements or to cover haircuts, but generally the market based finance model requires lower levels of capital.

A number of developments within the financial intermediation sector in the run-up to the crisis and during it can be traced to the differences between these two business models.   These include changes in liquidity and solvency levels, changes in lending appetite including credit criteria, and changes in credit spreads.

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[1] There will repos with a variety of different counterparties.  Distinct collateral is used for each counterparty; they do not share in the same collateral pool.