Focus On Convexity: How It Applies To Banks
Now that we have established a solid understanding of what convexity is and how it applies to markets as well as life in general, we can use it as a lens through which to view the financial system.
Banks have a business model that is short convexity.
Which is quite surprising, considering that convexity is a term and concept that comes from bond math. While commercial bankers can be excused for not knowing this since they do not generally deal with bonds, only loans; investment bankers, especially fixed income ones, really can’t.
Consider the commercial bank’s business model. They take deposits and make loans (deposits are not loaned out), pocketing the difference in the interest they pay for the deposits and the interest they earn on the loans.
The idea is to minimize the losses from clients defaulting on their loans through strict credit checks, risk management, and to some extent developing a relationship with clients and really understanding how their business is run.
Unfortunately, large loan losses are the norm and not the exception.
A single large loss in a financial year can be large enough to wipe out the entire year’s profit. Famous examples of this over the past few years include the Wirecard collapse and the Greensill collapse.
Going back to our pennies and steamrollers analogy, the commercial bank earns its pennies from interest differentials, but exposes itself to the steamrollers of large clients defaulting.
They are also exposed to rare economic blowups where multiple clients of varying sizes default at the same time, a la 2008.
Needless to say, large defaults can lead to commercial banks themselves falling into insolvency; such is the nature of being short convexity.
Things are not much different on the investment banking side, where many institutions run prime brokerage businesses. Prime brokers provide many services to hedge funds, including extending them leverage.
This puts them in the same boat as commercial bankers, just with different clientele, and with far more spectacular blowups. Archegos is the most recent example of this, with Credit Suisse making just $17.5 million in fees from the family office before racking up $5.4 billion in losses!
Pennies and steamrollers indeed.
Ultimately what all these financial business models have in common is that they make money by collecting spreads. “Spreads” here simply refer to the difference in loan rates and funding costs (our proverbial pennies).
Naturally, the collection of these spreads is an extremely lucrative business, which would account for the vast profitability of banking institutions, and why so many compete in the space.
However, the large sums of money being earned are ultimately exposed to the greatest risk of all: total loss.
“Total” because, in the worst cases, the business itself is on the line.
That’s multiple years of spreads painstakingly earned and retained for shareholders on the company’s balance sheet, always at risk of disappearing in a flash.
As such, banks really are not as safe as they, or regulators make them out to be.
This isn’t to discourage you, as a reader, from investing in banks, whether as a shareholder/bondholder.
When times are good, bank stocks tend to pay healthy dividends – but it would be wise, and necessary, to understand that investing in a business that is inherently short convexity makes you short convexity as well.
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