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Confidence key for banks

By Claes Bell, CFA · Bankrate.com
Thursday, August 25, 2011
Posted: 2 pm ET

Banking giants the world over are struggling with falling stock prices, but Bank of America has had a particularly tough month. BoA executives watched in dismay as the bank's stock price plummeted in August, reaching a low of $6.01 this week before surging on news that Berkshire Hathaway founder Warren Buffett had made a massive investment in the banking giant.

Part of BoA's slide has been driven by fundamentals; it still has significant exposure to asset classes wrecked by the financial crisis, including billions of dollars worth of home equity loans and commercial real estate loans that may be worth less than the company values them at now. BoA also has some exposure to European government bonds, which aren't exactly the best investment right now.

But what's happened to BoA is also a case study of why it's really hard for a bank to regain the market's confidence once it's been called into question.

If you want to know how important confidence is to a big bank, understand that a big selloff of BoA shares on Tuesday was driven in part by a blog post. You read that right: a thousand-word blog post written by Business Insider CEO and blogger Henry Blodget triggered a market response so severe, the bank felt compelled to release a statement rebutting Blodget's figures and calling his honesty into question. Confidence in your institution can't be great when a speculative blog post can do that kind of damage.

But what BoA is experiencing is in some ways inherent to the way modern banks do business. A recent analysis of the gold standard and government intervention in global by University of California, Berkley economist Barry Eichengreen published in The National Interest sums it up quite nicely:

The problem, then as now, was the intrinsic instability of fractional-reserve banking. Banks are financial intermediaries. They are in the business of lending out the money they borrow from their depositors. This means that they keep on hand as reserves only a fraction of their deposits. But this exposes them, by their very nature, to a problem of confidence. As in the famous scene in "It's a Wonderful Life," if depositors lose confidence in the security of their funds, for any reason, they will demand them back, but the bank will not have them in liquid form. Moreover, because banks operate in the information-impacted part of the economy -- they are in the business of acquiring information about specialized borrowers whose prospects are difficult for arms-length capital markets to assess -- information about their own financial condition is necessarily imperfect. This is why confidence problems are intrinsic to fractional-reserve banking …

This inherent imperfection of our understanding of a bank's financial condition leaves, combined with continued doubts about the global economy and recovery from the financial crisis, has investors and other bank stakeholders so starved for information that even speculation of the type that Blodget's blog offers can be really damaging to even a huge multinational bank like BoA.

Because of this, BoA is caught in something of a Catch-22. They can't remain silent about their finances, because even if they weren't a public company required by law to do extensive financial reporting, the media would likely criticize them for their secrecy and read weakness in it. On the other hand, if BoA executives assert their bank's safety and soundness in the media, they get words like this from Blodget:

In fact, in what is fast becoming a formal law of bank-stock thermo-dynamics, the more the bank insists that everything's fine, the more investors take this as a signal to run for the hills.

Meanwhile, the more the bank's stock drops, the more expensive and painful it will be for it to raise cash if and when it finally admits that the market was right all along (the next formal law of bank stock thermo-dynamics being that the market is generally right.)

Maybe Blodget is right, and the bank really does have $200 billion or more in hidden liabilities and a need to raise billions in capital just to stay afloat. But what if he's wrong and Bank of America turns out not to need any additional capital? How exactly would they go about proving that to him, now that he's said that any attempt to prove that will just make them more suspect? He cites the market as being "generally right," but was that also true when BoA shares were trading over $50 during the height of the real estate bubble?

In the end, it all comes down to a confidence game. In good economic times, investors and depositors alike rarely question a bank's safety and soundness. But when times are bad, they see the ghost of Washington Mutual behind every earnings report and public statement.

I'm no expert on the health of BoA's portfolio, and for all I know, Blodget and other BoA doubters are right. Fortunately for BoA, however, Warren Buffett doesn't appear to see the bank teetering over some $200 billion precipice and has stepped in and made a multi-billion dollar investment in the bank.

That may not reassure all BoA stockholders, but if you're a BoA accountholder, you're probably going to be just fine. BoA still enjoys a four-star rating from Bankrate's Safe and Sound rating system, and BoA accountholders who keep their balances at or below $250,000 are protected by FDIC insurance regardless of how the BoA drama plays out.

What do you think? Are banks particularly vulnerable to crises of confidence? Do you think doubts about BoA and the banks are overblown?

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