Confidence Is Banking's No. 1 Asset

Undoubtedly the most important lesson bankers and other financial executives have had to learn or relearn in the current crisis is that public confidence is the most important asset any financial institution has.

This is one point that bankers used to recognize.

Otherwise, how would we have developed a tradition of conservatism in dress and action that has been typical of bankers through the years?

Silent Bank Runs

We have seen recently that many banks have faced so called silent bank runs when confidence in their operations has faded. This has involved simple nonrenewal of certificates of deposit and other time deposits and the quiet pulling down of other deposits to below the federal insurance ceiling.

And we have even seen actual bank runs - with people waiting in line for their money, despite the government's insurance guarantees, after rumors of trouble have surfaced.

In this regard, I remember talking recently to the head of the New York office of a major European bank that is still rated AAA - something no U.S. bank can still boast.

"I guess you have gotten a lot of loan demand due to the inability of American banks to make all the loans they formerly could," I said.

"No," he replied. "We are getting instead new deposits from people who want to make sure that their banked money is safe, secure, and liquid."

Confidence is so important because virtually no bank could meet its withdrawal requests without severe loss if heavy demands were placed on it. For unless a bank limits its loans and investments to those with absolute liquidity - something it could not afford to do and still earn enough to keep operating - any forced sale of assets is likely to be at a price below book or even below stated market value.

Additionally, since banks can record assets at historical cost until sold, this would make the organization's actual value in case of a substantial liquidation of assets considerably below stated book value. But happily, this seldom happens.

Regulators who allowed thrifts to use mark-to-market accounting in the 1980s in order to let the institutions show a profit when their expenses actually exceeded income justified this policy in retrospect by saying:

"Look, if we had not allowed these profits that stemmed from creating |goodwill,' the thrifts would have gone under. But by allowing this new accounting approach, we kept them alive until declining interest rates bailed them out so that many made it who wouldn't have survived otherwise."

Health: Time Plus Confidence

Sure, we have had many notorious cases in which this new accounting just gave the thrifts' enough time to generate even greater losses. But in many cases, the practice did give institutions time to recover - when their troubles stemmed solely from high interest rates and not from bad loans.

The key was, of course, public confidence, kept alive by these unusual and ingenious accounting techniques.

One can go further: The Great Salad Oil Swindle of the 1960s came to light when salad oil prices fell and the speculator who had borrowed against oil he then sold was asked to deliver the oil he no longer owned. Had salad oil prices gone up, though, he would have been a hero rather than a jailbird.

Confidence Collapsed First

Even in the notorious failure of Bevill, Bressler & Schulman Inc. - the largest government securities dealer ever to go bust - if the public had maintained confidence and not asked for the collateral behind their repos to be returned, no one would have known that the collateral was being used two or more times. The firm might have ridden out the storm until interest rates fell and its portfolio regained the losses suffered as rates rose.

In sum, very few financial institutions are strong enough to stand runs by creditors.

The decline of the thrifts led to public fears for the banks, which brought about bank liquidity crises. Now, in turn, the banks' decline has led to fears about many insurance companies, which has brought some of them to grief.

A Bad Trade

And what we must conclude is that, in their quest for quick profits, through up-front fees, and long-term profits, through acquiring risky assets, all types of financial institutions have traded away their most precious asset - public confidence - for short-term gains.

And in the process, they have damaged the only asset that has any longstanding value - the power and prestige that used to be attached to the terms "insurance" and "money in the bank."

Until the public can be persuaded to trust again, our financial sector can never be as powerful and secure as it once was.

Mr. Nadler is a contributing editor of the American Banker and professor of finance at the Rutgers University Graduate School of Management.

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