Could TradFi Risk Playbooks Have Saved Crypto Lenders?
Originally a thread on X/Twitter:
We’re in the middle of a crash and burn crypto cycle with “Exhibit A” being a handful of large lenders unable to meet their obligations due to “technical insolvency”.
Could TradFi policies have prevented these meltdowns?
The answer isn’t clear but is worth exploring.
Banks have a very diverse set of products and services, but the foundation underpinning most Banks is the generation of profit through lending activities.
Money in and money out. Banks accept deposits and use them to make loans.
People deposit cash with the understanding that they can get it back at an agreed-upon future time.
Banks lend the deposited money to borrowers and expect to be paid back the loan amount plus interest.
This “financial intermediation” can be very profitable if managed well.
Banks have to pay out depositors when they want access to their money and notice is rarely given.
In contrast, borrowers are typically on fixed repayment schedules and these schedules aren’t tethered to the deposits being lent to them.
This creates a problem: Duration.
Most lending products are structured around multi-year payback periods (i.e. – 5-year car loans, 30-year mortgages, etc) while most deposit products are structured around shorter duration lock-ups (i.e. – demand deposits, short-term CDs, etc.)
Banks fundamentally “borrow short” and “lend long”. If it sounds scary it’s because it is scary!
A fundamental role of Banks is in the MATURITY TRANSFORMATION of short-term deposits into long-term loans WHILE MANAGING LIQUIDITY AND INTEREST RATE RISK!
The challenges created by short borrowing and long lending are complex and require oversight.
The “Results of Material Loss” reviews performed by the FDIC, OCC and NCUA consistently find that failed institutions have weak asset liability management (ALM) strategies!
But ALM strategies are complicated to design, monitor and adhere to in the real world. No Bank has a single deposit product and a single lending product. Banks are a combination of business units with a treasury department charged with managing the aggregate risk exposure.
At a typical Bank, each business unit is assigned a cost of funds based on the riskiness of its assets. And long duration assets also have to pay an additional “tax” to the treasury department which is used to pay for swaps and hedges.
By centralizing interest rate and duration risk under the treasury department, policies can be put in place (an ALM strategy) and a committee can be spun up to monitor them (an ALCO committee).
Serving on an ALCO isn’t fun but it’s one of the most important roles within a Bank!
ALCOs look for mismatches that threaten the profitability and solvency of a Bank.
ALCOs play a pivotal role in raising issues surrounding risk, liquidity, and interest rate fluctuations.
ALCOs provide a sobering voice to parties that wish to unnecessarily risk a Bank’s assets.
A well-run committee has more than a dozen policies to monitor and ALCO members have to understand how the macro is changing as well as how specific loan products perform. This isn’t a “fog a mirror” committee.
Examples of principles behind ALCO policies:
Principle: A Bank is responsible for the sound management of liquidity risk and should always maintain sufficient liquidity, including a significant cushion of high-quality liquid assets that can withstand a range of stress events including loss or impairment of funding sources.
Principle: A Bank should conduct stress tests on a regular basis for a variety of well-defined short, medium and long-term stressed scenarios (institution specific and market wide) to identify the impact of and plan for any potential liquidity strain.
Principle: A Bank should have a formal contingency funding plan that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations along with clear lines of responsibility for making decisions and communicating with stakeholders when in crisis.
Principle: A Bank should maintain a cushion of unencumbered, high-quality liquid assets to be held as insurance against adverse liquidity stress scenarios, including those that involve the loss or impairment of currently available secured funding sources.
Principle: An external, unaffiliated party should regularly perform a comprehensive assessment of a Bank’s overall liquidity risk management framework and liquidity position to determine whether they deliver an adequate level of resilience given the Bank’s size/importance.
With this framework in mind, one needs to ask if better thought out ALM strategies and better run ALCO committees would have prevented the recent meltdown.
And the answer isn’t obvious because product issues can’t be overcome by good governance.
To this end, many crypto lenders suffer from the same problems that have haunted non-Bank lenders. The products they offer can become untouchable by the capital markets in certain market conditions, and these market conditions pop up once or twice a decade.
Banks have a structural advantage by being able to tap into a Lender of Last Resort (LOLR) network as well as having access to deposit insurance. Most non-Banks can’t tap into these resources nor can today’s crypto lenders.
Definitionally, a LOLR is an institution that acts as the provider of liquidity to another financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market. It’s basically a government guarantee to provide liquidity to Banks.
Definitionally, the primary purpose of deposit insurance is to prevent run on the bank scenarios (which devastated Banks during the Great Depression). Macro and micro concerns can cause small groups of worried customers to rush to withdraw money which can put a Bank at risk.
But these safety nets aren’t available to non-Banks or crypto lenders which puts them at risk in certain scenarios. Great ALM policies and attentive ALCO Directors can prevent major mistakes at lending institutions, but they can’t overcome certain structural issues.
In order to stop the liquidity issues underpinning the financial crisis in 2008, extraordinary actions by our government and governments around the world were needed. They had to provide non-Bank lenders with similar safety nets to the conventional banking system.
The Federal Reserve served as a liquidity provider of last resort to the system. The FDIC increased deposit insurance limits. The Treasury Department created an insurance program for money market funds and passed TARP which provided equity capital to troubled institutions.
Who knows what would have happened if the government hadn’t stepped in, but what we can assert is that there would have been a significant amount of collateral damage to consumers, businesses, and our economy as a whole.
Does this mean that non-Bank and crypto lenders shouldn’t exist?
There are people who firmly believe this is the case.
But there are others who believe that non-Bank and crypto products can be transformed and properly managed to be durable in all but the most dire scenarios.