Thursday, September 20, 2007

How banking works ...

I thought I'd explain the current banking crisis in plain English. It works like this ...

  • People (who happen to be tax payers) save money in say bank A.
  • Bank A lends this money as loans to other people to buy stuff, say properties.
  • Bank A then borrows money from Bank B on guarantee of the loans business.
  • Bank A lends this money again as loans to other people.

and so on, and so on.

Obviously this means the original money is lent many times. Many banks have more loans than savings. It works as long as most of those people honour their debt.

But what happens when people start defaulting on their debt?

Well Bank B starts getting nervous about lending money to Bank A on guarantee of defaulting and possibly worthless loans. A credit crunch occurs. Over stretched banks start to have problems etc.

How do you solve this?

Well, one way is for the central bank (funded by tax payers) to lend huge amounts of cash to the banks in return for the dubious (low quality) loans business.

That way the banks keep going, bonuses remain high, Ferraris still get bought and who pays if all goes wrong? Well we all do, as tax payers.

A sort of, I win then I keep the cash, I lose and we all share the cost.

I can certainly understand the "moral hazard" that such action creates and how it can encourage excessive risk taking. It's like borrowing someone else's money, putting it down on laughing boy, 3rd race, Catford dogs and if it doesn't come in - get your money back from the central bank in exchange for the betting slips.

Sounds like a good business to be in. Unless of course in the long run, you're an average joe public tax payer who saves.

Glad to hear that Mervyn didn't change his mind .... damn, he did.