Will Customer Fee Increases Hurt the Big Banks?

Recent bank fee increases are pushing consumer funds to credit unions and other financial firms. (See http://www.cnbc.com/id/44930883.) This is understandable from the consumers' standpoint. Why enrich banks when you're barely making ends meet? A less obvious question is whether these fee increases are bad for banks.

Banks play a potentially dangerous game. They make medium and long term loans and investments, using short term money (i.e., money that can be withdrawn quickly). Because short term deposits and other borrowings tend to cost banks less in interest expense than medium and long term loans generate in interest income, banks make profits on the difference. This game works fine as long as the short term depositors and other creditors of banks don't bolt. But, as we all know from recent financial upheavals, a run on the bank results muy pronto in its collapse--unless it's so big that the government steps in and gives the bank a blank check drawn on taxpayers.

Consumer deposits tend to be stable. This is true even for nominally short term accounts, such as checking accounts that theoretically can be closed on demand. It's a hassle for consumers to change banks, especially now that they often have direct deposits made to their accounts and direct bill paying from their accounts. The banks that have been raising fees are betting that a lot of customers will find it too bothersome to switch accounts, and will cough up $5 a month for a debit card or whatever.

But many customers may leave, particularly after a few months or maybe many months. While the banks will probably profit short term by raising fees, after a while growing numbers of customers may tire of paying for what's free elsewhere. If banks see a shrinkage in their retail deposit base, what will they do? They can either reduce their balance sheets (i.e., reduce the loans and investments they hold) or they can seek alternative funding. Banks, as a rule, don't shrink their balance sheets. If you're a bank CEO, you aren't likely to perceive a lot of benefit to making your organization smaller. The more assets the bank holds, the more profits it will hopefully make and the larger your bonus will hopefully get.

Since banks losing consumer business won't be inclined to shrink their balance sheets, they will seek alternative funding. The choices are likely to be much less stable than consumer deposits. Typical alternatives would include the fed funds market, the commercial paper market and the repo market. Funding from these markets is susceptible to great instability. Money a bank borrows in these markets can evaporate faster than a hedge fund can execute a computerized trade.

Europe's big banks are funded to a large degree in wholesale markets, more so than many of America's big banks, and are consequently less stable. That's one reason why the EU sovereign debt crisis became so acute so fast earlier this year--the money market vigilantes fled the big EU banks, and Europe's governments had to ride to the rescue. (If you have an account with a U.S. money market fund, though, your fund may have been one of these vigilantes and you'd probably consider this a good thing.)

If America's big banks experience a large enough shift in their liabilities, with less retail deposits and more wholesale funding, their risk profiles could change and not in a good way. Are bank executives are concerned? Come on. If a big bank goes way out on a limb and the limb starts to break, the Federal Reserve will climb into its Black Hawks and helicopter to the rescue. But taxpayers should be concerned. If America's big bank risk profiles tilt toward the European model, the potential for bailouts increases.

The risks of reliance on wholesale funding are well-illustrated by Lehman Brothers' collapse in 2008. When the word got around the Lehman was struggling, its funding dried up faster than rich people rushed out of New Orleans as Hurricane Katrina approached. That one time, the Fed and the Treasury Department didn't deliver a bailout by courier. They've been harshly criticized ever since. So you can bet your bippy that no large bank will ever again be allowed to fail. Period. That's why, long term, it might end up being a bad thing if consumer deposits leave big banks. Regulators should require more capital as banks' risk profiles become hinkier. Then again, a lot of things that should be done aren't.