Wholesale deposits

Here's a dilemma for a small bank. You have £20m of "spare" liquidity. What do you do with it? a. Deposit it all with Barclays? b. Deposit it equally with Barclays, HSBC, Lloyds and RBS? c. Deposit it in different amounts across ten counterparties? d. None of the above? This is a question I've been asked twice in the past week. So what's the right answer? That depends. Do you believe in diversification? Diversification assumes that by spreading risk it is reduced. As a cornerstone in modern portfolio theory it sometimes works. But there is a problem when everything falls at once. Do you believe in "too big to fail"? Many do. And that's why counterparty lists have become smaller with large banks getting the lions share. Do you believe in Warren Buffet? He has said that concentration reduces risk because you focus on looking at the investment more closely. Do you believe in trust? Big banks don’t even trust each other. That's why they are reluctant to place deposits without taking collateral. You may call this pawn broking - the technical term is repo. Do you believe in ratings? A lot of people blame the agencies for failure but they still use the system to determine investment. Do you believe in following the trend? Place it overnight at least (with luck) you get it back tomorrow. Do you believe profit is the reward for risk? You are an outlier and probably not suited to banking in its current form. In short there isn't a right answer. How profitable are you? How much capital do you have? How much risk do you want to take? Place it all with Barclays and if you take a 50% haircut you will be finished. Try the big four, argue it's safer and correlation will do the same thing. Try ten and there's more risk of losing less. Try repo, that's if you can get someone to play. Perhaps you buy Gilts and nothing else. That's one answer I got last week. Now here is the punch line. A lot rides on chance and candidates in multiple choice tests can rely on Lady Luck. The only thing is that the adjudicator knows this too. It's not so much the answer you give but the workings you show that get you marks.