opinions?

phantom_lord

Bank Failures

We have written before about the remarkable ability of banks to create money when making loans, and of their equally remarkable ability to multiply these newly created-from-nothing bank deposits via fractional reserve banking. What we have written is true, and easily verified.

But banks fail! That fact is equally true, and easily verified as well. How can we reconcile these apparently contradictory facts? If banks can create, and multiply, money, how can they fail? Could your business fail if what you made was, literally, money, or what people took for money?

The qualifier is important. It is what people assume about money that makes modern banking possible. The Federal Reserve itself points out that it is the people's confidence that make paper devices serve for money. Belief (i.e., "credit") is what keeps the system going. Psychology is everything.

If modern money is an illusion, then bank failures are an important means of reinforcing that illusion. Consider the alternative. If a bank made loan after loan, and these loans were not repaid, and the bank continued to do business year after year with mounting millions of bad loans on its books, wouldn't that look odd? People would question how the bank could continue to thrive despite so many bad loans. Would they maintain their confidence in the system if the banker cheerfully admitted that he made those loans by simply crediting the borrower's account, and that to do so cost him nothing? Some might wonder why the bank would not honor checks written on insufficient funds, if the banks create those funds from nothing. Corporations which are unable to meet their financial obligations to banks might wonder why they must work to repay the bank for something it got with a flick of a loan officer's pen.

No, it is important, if confidence is to be unshaken, that banks appear to be like other businesses, when, of course, they are nothing like other businesses. This means that banks must be allowed to fail, even though they are the source of modern money.

Failure occurs when liabilities outweigh assets. What are a bank's assets? The IOUs of its customers. Its liabilities are their deposits. If a customer has borrowed a million dollars from the bank, and given the bank his IOU for that number, the bank has a million dollar asset---unless the borrower goes belly-up, and defaults on his loan. Or declares bankruptcy. His million dollar note then becomes worthless. But if his borrowed million dollars is on deposit in that bank, the liability of the bank for a million dollars remains.

Most banks can probably absorb a million dollar "loss." But if the borrower was a foreign government, and the amount created, or loaned, was a billion dollars, that's another matter.

When money is loaned, it is created: instant new money, or inflation. When a loan is repaid, the money goes out of existence. Money creation, or lending, is balanced by money annihilation, or repayment. What difference does it make to the bank, then, if a borrower fails to repay? Either way, the money supply is reduced. The difference is interest, which is the bank's profit. Merely adding to the money supply with each loan offers no benefit to the bank. The interest on a billion dollars is substantial, however, so to keep that interest coming, the bank will bail out a foreign government which is unable to service its loan. It may not do this directly, but through a bank consortium, or government front, such as the IMF, or World Bank. Again, appearances are important. The bank cannot be seen lending more money to a borrower who has demonstrated his inability to repay, but a group of banks, perhaps under some governmental aegis, can get away with it. You or I would do the same, probably, if we could.

For example: if you could loan your brother a million dollars simply by giving him a piece of paper on which you had written ONE MILLION, why wouldn't you do so? The numbers which you write are "money," and it costs you nothing to make the loan. You keep his IOU for a million, and reduce it by whatever amount he repays each month. Where's the profit? The profit is interest. If he is paying you, say, five thousand a month in interest, that is "money" you can spend. If he declares bankruptcy, no more interest. To prevent that, you lend him still more. The amount loaned is only important in determining the interest. If he never repays, so what? The interest is what drives the process, and since loan repayment means the eventual drying up of interest payments, you are delighted if he never repays the principal.

Banks are pleased to make immense loans to governments, because governments seldom repay the principal, which means interest payments will go on forever. If a government falters in its payments, other governments will often come to its aid, especially governments owned by the lending banks. The banks must, as we have said, fail if the really big borrowers go under, if confidence in the monetary system is to be maintained. Governments do not want large-scale bank failures, because they want their monetary unit to be regarded as "strong" and "stable." Governments thus share with the banks the concern that banking appear like any other business, with failures resulting when liabilities overwhelm assets.

So banks must fail. Confidence in the system demands it. Maintaining the illusion demands it. Bank failures, though, are somewhat different. We have seen those heart-wrenching pictures of farm families huddled together as their assets are auctioned off at a bankruptcy sale. We never see pictures of the banker and his family weeping when the bank fails. Indeed, within a short time, it's business as usual, but with a different name on the building, and different management within. Does the former banker have to take a job in a factory to make ends meet? Do his children have to drop out of school and go to work? Will he face charges for check-kiting, or counterfeiting? It doesn't seem likely. The illusion can be maintained without such extreme measures!

John Maynard Keynes put it succinctly: "If, however, a government refrains from regulations and allows matters to take their own course, the worthlessness of the money becomes apparent, and the fraud upon the public can be concealed no longer." Expect to see more bank failures as the economy declines. Otherwise, the worthlessness of the money might become apparent!

me,myself and i

Interesting. Certainly raises a few points.

hmmm

It was interesting enough reading from a first year economics paper, until the bank manager bit down the end reminded me of some left wing rant.

A couple of Japanese banks went bust during the recent (current?) recession, many because their assets were mortgaged against a property market which crashed (never happen in Ireland right!).

Banks have to maintain a certain amount of what you might call "real" capital for regulatory purposes, primarily to maintain confidence in the financial system (see Basel).

Redmon

I am sorry, but this is not the real world.

Banks and financial institutions provide the spine to any national - or multi-national - economy. Banks that fail are punished. A corrupt or incomptent financial sector strangles any hope of economic growth or prosperity. That is why all developed economies have relatively efficent and capable banking sectors.

In all developed economies, banks are owned (directly and indirectly) by private shareholders: you and I. When a bank underperforms its profits and free cash flow falls. It finds that it cannot repay debt that it itself has borrowed, or it cannot lend to boost its sources of recurring income. Its debt rating comes under pressure and its share price falls (you and I - or our pension fund) manager sells the banks stock: the bank is punished. The bank is taken over and its work and practices are reformed.

I am not trying to lecture but there are details you have omitted: capital adequacy regulations; Basel rulings; BIS; the requirement of banks to report non perfoming loans on an regular basis etc.

Karl Marx believed the wheel of revolution will eventually turn full circle: capitalism would be finally defeated. That was 130 years ago. I think a lot of people have stopped counting by now.

Nermal

Redmon wrote:

I am not trying to lecture but there are details you have omitted: capital adequacy regulations; Basel rulings; BIS; the requirement of banks to report non perfoming loans on an regular basis etc.

exactly, these are what promote confidence in the system, not bank failures. failures damage confidence because it means these rules have been ignored.

i suppose you can say *failures are sometimes the consequence of what is required to maintain confidence*... but to say 'banks *must* fail is flat out wrong.