The alchemy of deposits

Patrick McKenzie (patio11)

The most basic product offered by banks is also one of the least understood. You’ve depended on its orderly operation your entire life. It runs society at microeconomic and macroeconomic levels. It required hundreds of years of trial and error, plus an edifice some would describe as the world’s largest conspiracy theory that is actually true, to make it safe enough to bet society on.

Behold the terrible majesty of the humble bank deposit.

Deposits are money

The model we are taught as children is, like most models, useful but inaccurate. “You take this $20 bill to a bank and deposit it. They will keep it safe for you, and then give you $20 back in the future, plus a little extra for having the use of it in the meanwhile. We call that interest.”

Let’s start dissecting this transaction. You don’t deposit a $20 bill. You purchase a $20 deposit, coincidentally using a piece of paper with the same number on it. The deposit is a liability (a debt) of the bank to you. The bill which you gave the bank in return for the deposit is now theirs, the same as if you had bought a cup of coffee from Starbucks. On their balance sheet, it is now an asset.

The core action which one takes with a deposit is not actually withdrawing it (plus a bit of extra interest). Most deposits will not be withdrawn by the person who originally put them in the bank.

The actual core feature of deposits is that you can transfer them to other people to effect payments. Big deal, you might think. You can also transfer cows, sea shells, Bitcoin, an IOU from a friend, or bonds issued by Google to effect payments.

But deposits are treated as money by just about everyone who matters in the economy, including (pointedly) the state. Economists can wax lyrical about what “treated as money” means, but the non-specialist gloss is probably just as useful: anything is money if substantially everyone looking at the money both agrees that it is money and agrees at the exchange rate for it. This is sometimes referred to as the "no questions asked" property; money is the Schelling point for value transfers that all parties to a transaction are already at.

This is so fundamental a feature of deposits that, in developed nations, we don’t remember that it isn’t automatic. There isn’t an ongoing exchange rate between Chase dollars and Bank of America dollars. Even attempting to imagine that invokes images of chaos. You’d have to specify a bank while doing a salary negotiation. Your rent might swing up or down based on the landlord’s judgment of your bank’s credit position. Newspapers might print daily charts, for the benefit of the business community, of the exchange rates for deposits of every bank in town, so that they knew how much extra to ask for when you wrote a check to settle a $20 purchase.

All of these, and more, used to happen.

They also happen today, in places without well-developed banking systems. Crypto is a good example, to avoid stigmatizing developing nations. There is an exchange rate, constantly changing, between the stablecoins USDC and USDT, between both of those coins (independently) and the dollars they theoretically represent. Different rates prevail in different places and different transaction sizes. This makes stablecoin-settled commerce very rare relative to money-settled commerce.

Heavily engineered structured products pretending to be simple

From the consumer’s perspective, deposits are “my money,” functionally riskless. This rounds to correct.

From the bank’s perspective, deposits are part of the capital stack of the bank, allowing it to engage in a variety of risky businesses. This rounds to correct.

The reconciliation between this polymorphism is a feat of financial and social engineering. A bank packages up its various risky businesses—chiefly making loans, but many banks have other functions in addition to the risks associated with any operating business—puts them in a blender, reduces them to a homogenous mix, and then pours that risk mix over a defined waterfall.

The simplest model for that waterfall is, in order of increasing risk: deposits, bonds, preferred equity, and common equity. Holders of all of these complex financial products have committed capital, under various terms, to the operation of the bank’s business. The more risky the product, the higher in general the return and the more risk of loss.

Careful balancing of the amounts of capital in the various categories, and of the portion of risk absorbed by equity in particular, is supposed to make deposits so safe as to never get any of the risk sludge spattered on them at all.

This happy just-so story has been told by every bank in history, and yet depositors actually periodically lost lots of money, and the banking system had large systemic crises, until it was backstopped by deposit insurance. That’s a deep enough rabbit hole that I’ll cover it in a later essay.

Why fund the risks of a bank with deposits, as opposed to funding them entirely with bonds and equity (and of course, revenue), like almost all businesses do? From the bank’s perspective, this is simple: deposits are very inexpensive funding sources, and the capability to raise them is the one of the main structural advantages banks have vis-a-vis all other firms in the economy. This allows banks to price loans much cheaper than non-bank lenders can afford to, sell vastly more loans (due to more demand for cheap loans), sell vastly more loans for any given level of capital, increase their return to equity holders, and similar.

From society’s perspective, the wide availability of cheap credit is generally considered a good thing, as it allows for productive investment, consumption smoothing over consumers’ lifetimes, and a form of risk-pooling not entire dissimilar to public support or insurance programs. (It is underappreciated that consumer credit is, effectively, one of the largest welfare programs in the United States. Chargeoffs of e.g. credit card debt effectively transfer a private benefit to the defaulting consumer in return for a diffuse cost to the rest of the public, mediated by the financial industry; the net amount of them is almost as much as food stamps.)

Deposits as pink slime

Pink slime gets a bad rap. It’s delicious, economical, and about as healthy as meat generally is. (Cultural note for non-American readers: pink slime is a weighted and generally disparaging name for what the food industry generally calls “processed meat product”; much of American processed protein is made of it. Chicken McNuggets, for example, really are chicken meat but they’ve been blended into a slurry then formed into the classic nugget shape, rather than being contiguous cuts from any individual chicken.)

Deposits, sitting on the liabilities side of a bank’s balance sheet, balance out a bank’s assets, including ones which are risky or illiquid such as the loan book. If your deposit at the bank corresponded 1:1 with an identifiable asset, you’d have to care about that asset, quite a bit. If your deposit was not merely spiritually funding my mortgage but actually backed by my mortgage, you’d watch my financial situation as if it were your own, because it would be. You’d be tempted to e.g. sell out of my mortgage and into, well, anything else if you thought I suddenly developed a taste for mixing expensive alcohol with more expensive poker tables.

And then the people doing business with you would be inconvenienced, as well, because while your payments would notionally be denominated in dollars they’d actually be backed by… something you understand a lot better than the person receiving the payment. And so they’d be less likely to transact without trust in you, demand a risk-based discount, delay transactions to do their own due diligence on me, and similar.

Specialists refer to this property as information sensitivity. (See this interesting read [PDF] on this topic.) The value of my mortgage is very tied to facts about my situation that an interested party could, through expenditure of effort, have an advantageous viewpoint on. It is information sensitive. The value of a deposit for 100 yen at the bank issuing my mortgage is precisely 100 yen, every child knows it, and no amount of malfeasance will allow you to harm someone by engaging in an otherwise fair transaction for 100 yen and satisfying it with that deposit. Deposits are information-insensitive debt.

Another benefit of deposits, quite controversial, is that they allow money creation via a public/private partnership between the government and commercial banks. We'll have to address that another day.

Many things are quasi-deposits

Banking is, when executed well, a very lucrative business to be in, and many firms and financial products replicate parts of it. These are sometimes described as “shadow banking”, which is a word which might conceal as much as it illuminates.

Be that as it may, unsophisticated customers perceive many things where a database shows an entry in dollars as deposits, and (sometimes worrisomely) those are actually sold as being equivalent to deposits. If they’re not money, they are not deposits.

Starbucks balances are a useful thing to have if you drink coffee, and are denominated in dollars (or here in Japan, in yen, etc etc). Starbucks balances are not deposits because nobody takes them except for Starbucks. (If someone asks for money, maybe you should give them money. If someone other than Starbucks asks for Starbucks balance, hang up because there is a 100% likelihood you are being defrauded.)

Many products are not as clear-cut as Starbucks balances. The fintech industry has not covered itself in glory here. Sometimes firms misclaim a product to be a deposit where it is not. Sometimes they actually institutionally misunderstand the nature of the product they have created.

One would hope that that never happens, but just like the most expensive mistake in the history of programming being the assumption that programmers can count, smart people are doomed to continue discovering that just because a deposit is a complex structured product involving a bank which has a stable dollar value, not every complex structured product involving a bank which appears to have a stable dollar value is actually a deposit.

Voyager, a publicly traded company, marketed a deposit-adjacent product to users, paying a generous interest rate. Then a cascading series of events in crypto, outside the scope of this essay, blew up a series of firms, including one which had taken out a loan of hundreds of millions of dollars from Voyager.

Suddenly, the information-insensitivity of Voyagers not-deposits was pierced, the pink slime appears both undermixed and undercooked, and customers now need to follow a bankruptcy proceeding closely.

(An interesting tangent is that, since all deposits are interchangeable by design—they are money, after all—that invariant is relied upon for the orderly operation of financial infrastructure. When something which was believed to be a deposit is discovered to not actually be a deposit, infrastructure around it breaks catastrophically. Matt Levine has an excellent extended discussion about how Voyager discovered that attaching the ACH payment rail to their deposit-adjacent product became a huge risk once they went under.)

Making the magic happen

Capital adequacy ratios, reserves, and the other not-so-secret sauce in banking are worth many books. Deposit insurance, a key ingredient in making deposits as reliable as they are perceived to be, is actually explainable in a reasonably compact form. Tune in for that next time.

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I write about the intersection of tech and finance, approximately biweekly. It's free.