It's not about the deposits, it's about the unsecured loans

Governments around the world have been acting to avert panics by retail bank customers, and they've mostly succeeded. That's a good thing, but it's also sort of beside the point. "Main Street depositors are keeping confidence," FDIC chairman Sheila Bair said when I talked to her last week. "It's other banks that are the problem."

The issue is that banks in the U.S. and other countries with long-running current account deficits pretty much by definition make more loans than they have deposits. John Hempton has been hammering on this for a while, so I'll let him explain:

If you run a current account deficit for long enough your financial system will be NET short deposits. There will be (say) 130 of loans for 100 of deposits. [If you are the UK it can be much more extreme – with Northern Rock having a loan to deposit ratio of a few hundred.] Individual banks will have sufficient deposits but everyone is vulnerable.

Banking can be profitable even if you are short deposits. Indeed it was silly-profitable for more than a decade before the insane lending started. The high levels of profitability meant that people would lend to banks unsecured in quantity at thin spreads.

Banks became totally dependent on their ability to roll the loans. If they can't roll this senior unsecured funding they will fail. No ifs, no buts. That results in failure.

Most banks in current account deficit countries have such funding. In Australia it is called Bank Bills. Here it is called lots of names only because financial innovation has found lots of ways to name the same stuff.

The money behind this senior unsecured debt comes from overseas, although it usually gets filtered through various intermediaries along the way. The standalone investment banks proved to be so vulnerable because they have no retail deposits at all, but again, even banking companies with big retail bases still depend heavily on unsecured loans. JP Morgan Chase, for example, had $723 billion in deposits at the end of June and what appears to be at least $310 billion in unsecured debt (I'm no balance sheet whiz, but I added up the line items for commercial paper and long-term debt from its most recent 10-Q and that's what I got).

What's been causing the various bank scares and failures of recent weeks has been an increasing unwillingness of anybody to extend these kinds of loans to banks. An at least partially rational unwillingness, given that senior unsecured creditors took big hits in both the Lehman Brothers bankruptcy and the seizure of Washington Mutual by the FDIC. Now you might argue that this is a healthy capitalistic development, one that will make providers of such credit more discerning in the future. But there's no way that a creditor could have discerned by looking at the balance sheets of the respective institutions that his money was in dramatically more danger at Lehman and Wamu than at Bear Stearns and Wachovia, where the government acted to protect creditors. It was purely a question of guessing what regulators would do, not weighing the risks of the financial institution.

Ireland recently acted to dispel such concerns by temporarily guaranteeing that all creditors of their countries' banks will be protected. Other European countries may follow. Writes the BBC's Robert Peston:

What we may need is a cast-iron pledge from all European governments that they will fill whatever funding gaps emerge at their respective banks from the seizing up of money markets.

Could this be the model for the U.S. too? I doubt it, at least not yet. Most European countries have only a few banks (Ireland has six). The U.S. has thousands. And I suspect that regulators here fear that any move to guarantee the debt of just a few big banks might be a death sentence for banks just below whatever size threshhold is chosen. They'd be overtly picking winners and losers, and they just don't seem ready to do that yet.

The new Fed-Treasury plan to buy unsecured commercial paper can be seen as a partial attempt to deal with this problem. Writes Krishna Guha in the FT:

The core of the problem in the interbank market is the lack of availability of term unsecured loans. Banks can get some term funding, but only on a collateralised basis, which helps explain the extreme demand for Treasury securities used for collateral purposes. Unsecured borrowing rates for any significant period of time – such as the three-month Libor (London interbank offered rate) – are sky high. In practice, most financial institutions are now unable to get term loans without collateral, and are funding themselves heavily in the overnight market.

The Fed hopes that if it begins offering such unsecured financing directly, the pressures on banks will ease. They might. But don't be surprised if, eventually, the Fed and Treasury and FDIC have to jury-rig some sort of blanket guarantee.