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.


Russ Nelson said...

This theory leaves out the recalculation problem. The reason that people default is because they invested wrongly. The assets which back up the loans aren't worth as much. THAT is why banks fail and other banks are reluctant to loan.

Having the central bank inflate the currency in the hopes of deflating it later when the economy gets going again ignores the fact that those assets (which include human assets) have to be revaluated. That takes time, during which people start suffering and demanding that politicians Start Doing Something. Thus you get politicians demanding that the central bank restart the economy by inflating the currency. Round and round you go.

swardley said...

This "theory" is a tongue-in-cheek parody which I wrote several years ago. The recalculation problem occurs when confidence crumbles and reality sets in.

However, the post was designed to illustrate the point which you highlight, that the assets have to be adjusted to reality. Unfortunately the alternative is to keep the merry-go-round going by increasing use of taxpayers funds to prop up an unsustainable system. This has three consequences :-

First, it gives an opportunity for the larger investors to get out of their positions and a new wave of investors to dive in as the correction is temporarily reversed. This is happening today, you only have to look at the volume of small investor trading to know that it's the small investors who are piling in and helping keeping things moving up along with taxpayers funds.

Second, it piles on a heavy debt burden to tax-payers whose funds are being used to help re-inflate the market. I particularly loathe the quantitative easing mechanism which is being used. A more honest system would be just print out huge wads of cash and then give it away to the investment community, as opposed to the "we will buy gilts at the top of the market and then sell them back to you at the bottom" farse.

Lastly, it does nothing to re-correct the underlying problems and almost certainly will amplify the effects of the correction.

Where we stand is we've currently poured truckloads of cash as bail-outs into the financial community, re-inflated the market to help them move out of bad positions, allowed smaller investors to dive in (as the FTSE gives the impression that it's recovering), saddled the taxpayer with the cost of this (along with some spectacularly daft re-insurance schemes and the potential of a bad bank) whilst we've simultaneously ignored inflation, allowed savers to watch the erosion of any nest egg they've created (encouraging them to dive into a re-inflated market) and left the underlying mechanisms alone which means correction will still happen.

With the exception of some sensible moves (buying equity in some banks rather than just handing over cash) you couldn't get it more wrong.

Keynes must be spinning in his grave.