Archive for the ‘Banking’ Category
by Keith Warner
Posted Jan 25, 2012
AS THE TITLE OF THIS ESSAY SUGGESTS, A LOAN IS AN EXCHANGE OF WEALTH FOR INCOME. Like everything else in a free market (imagine happier days of yore), it is a voluntary trade. Contrary to the endemic language of victimization, both parties regard themselves as gaining thereby, or else they would not enter into the transaction.
In a loan, one party is the borrower and the other is the lender. Mechanically, it is very simple. The lender gives the borrower money and the borrower agrees to pay interest on the outstanding balance and to repay the principle. As with many principles in economics, one can shed light on a trade by looking back in history to a time before the trade existed and considering how the trade developed.
It is part of the nature of being a human that one is born unable to work, living on the surplus produced by one’s parents. One grows up and then one can work for a time. And then one becomes old and infirm, living but not able to work. If one wishes not to starve to death in old age, one can have lots of children and hope that they will care for their parents in their old age. Or, one can produce more than one consumes and hoard the difference.
One discovers that certain goods are better for hoarding than others. Beyond a little food for the next winter season, one cannot hoard very much. One of the uses of the monetary commodity is to carry value over time. So one uses a part of one’s weekly income to buy, for example, silver. And over the years, one accumulates a pile of silver. Then, when one is no longer able to work, one can sell the silver a little at a time to buy food, clothing, fuel, etc.
Like direct barter trade, this is inefficient. And there is the risk of outliving one’s hoard. So at some point, a long time ago, they discovered lending. Lending makes possible the concept of saving, as distinct from hoarding. It is as significant a change as when people discovered money and solved the problem of “coincidence of wants”. This is for the same reason: direct exchange is replaced by indirect exchange and thereby made much more efficient.
With this new innovation, one can lend one’s silver hoard in old age and get an income from the interest payments. One can budget to live on the interest, with no risk of running out of money. That is, one can exchange one’s wealth for income.
If there is a lender, there must also be a borrower or there is no trade. Who is the borrower? He is typically someone young, who has an income and an opportunity to grow his income. But the opportunity—for example, to build his own shop—requires capital that he does not have and does not want to spend half his working years accumulating. The trade is therefore mutually beneficial. Neither is “exploiting” the other, and neither is a victim. Both gain from the deal, or else they would not agree to it. The lender needs the income and the borrower needs the wealth. They agree on an interest rate, a term, and an amortization schedule and the deal is consummated.
I want to emphasize that we are still contemplating the world long before the advent of the bank. There is still the problem of “coincidence of wants” with regard to lending; the old man with the hoard must somehow come across the young man with the income and the opportunity. The young man must have a need for an amount equal to what the old man wants to lend (or an amount much smaller so that the old man can lend the remainder to another young man). The old man cannot diversify easily, and therefore his credit risk is unduly concentrated in the one young man’s business. And bid-ask spreads on interest rates are very wide, and thus whichever party needs the other more urgently (typically the borrower) is at a large disadvantage.
Of course the very next innovation that they discovered is that one need not hoard silver one’s whole career and offer to lend it only when one retires. One can lend even while one is working to earn interest and let it compound. This innovation lead to the creation of banks.
But before we get to the bank, I want to drill a little more deeply into the structure of money and credit that develops.
Before the loan, we had only money (i.e. specie). After the loan, we have a more complex structure. The lender has a paper asset; he is the creditor of the young man and his business who must pay him specie in the future. But the lender does not have the money any more. The borrower has the money, but only temporarily. He will typically spend the money. In our example, he will hire the various laborers to clear a plot of land, build a building and he will buy tools and inventory.
What will those laborers and vendors do with the money? Likely they will keep some of it, spend some of it… and lend some of it. That’s right. The proceeds that come from what began as a loan from someone’s hoard have been disbursed into the economy and eventually land in the hands of someone who lends them again! The “same” money is being lent again!
And what will the next borrower do with it? Spend it. And what will those who earn it do? Spend some, keep some, and lend some. Again.
There is an expansion of credit! There is no particular limit to how far it can expand. In fact, it will develop iteratively into the same topology (mathematical structure) as one observes with fractional reserve banking under a proper, unadulterated gold standard!
Without banks, there are two concepts that are not applicable yet. First is “reserve ratio”. Each person is free to lend up to 100% of his money if he wishes, though most people would not do that in most circumstances.
And second is duration mismatch. Since each lender is lending his own money, by definition and by nature he is lending it for precisely as long as he means to. And if he makes a mistake, only he will bear the consequences. If one lends for 10 years duration, and a year later one realizes that one needs the money, one must go to the market to try to find someone who will buy the loan. And then discover the other side of that large bid-ask spread, as one may take a loss doing this.
Now, let’s fast forward to the advent of the investment bank. Like everyone else in the free market, the bank must do something to add value or else it will not find willing trading partners. What does the bank do?
As I hinted above, the bank is the market maker. The market maker narrows the bid-ask spread, which benefits everyone. The bank does this by standardizing loans into bonds, and the bank stands ready to buy or sell such bonds. The bank also aggregates bonds across multiple lenders and across multiple borrowers. This solves the problem of excessive credit risk concentration, coincidence of wants (i.e. size matching), and saves both lenders and borrowers enormous amounts of time. And of course if either needs to get out of a deal when circumstances change, the bank makes a liquid market.
The bank must be careful to protect its own solvency in case of credit risk greater than it assumed. This is the reason for keeping some of its capital in reserve! If the bank lent 100% of its funds, then it would be bankrupt if any loan ever defaulted.
What the bank must not do, what it has no right to do, is lend its depositors’ funds for longer than they expressly intended. If a depositor wants to lend for 5 years, it is not the right of the bank to lend that depositor’s money for ten! The bank has no right to declare, “well, we have a reserve ratio greater than our estimated credit risk and therefore we are safe to borrow short from our depositors to lend long”
Not only has the bank no way to know what reserve ratio will be proof against a run on the bank, but it is inevitable that a run will occur. This is because the depositors think they will be getting their money back, but the bank is concealing the fact that they won’t behind an opaque balance sheet and a large operation. So, sooner or later, depositors need their money for something and the bank cannot honor its obligations. So the bank must sell bonds in quantity. If other banks are in the same situation, the bond market suddenly goes “no bid”.
The bank has no legal right and no moral right to lend a demand deposit or to lend a time deposit for one day longer than its duration. And even then, the bank has no mathematical expectation that it can get away with it forever.
Like every other actor in the market (and more broadly, in civilization) the bank adds enormous value to everyone it transacts with, provided it acts honestly. If a bank chooses to act dishonestly (or there is a central bank that centrally plans money, credit, interest, and discount and forces all banks to play dirty) then it can destroy value rather than creating it.
Unfortunately, in 2012 the world is in this sorry state. It is not the nature of banks or banking per se, it is not the nature of borrowing and lending per se, it is not the nature of fractional reserves per se. It is duration mismatch, central planning, counterfeit credit, buyers of last/only resort, falling interest rates, and a lack of any extinguisher of debt that are the causes of our monetary ills.
by Rick Ackerman
Posted September 14, 2011
WITH BANK OF AMERICA’S RECENT ANNOUNCEMENT THAT IT PLANS to lay off 30,000 workers, the Great Recession has finally spread its shadow over a sector of the economy that had seemed inured to hard times.
Investment consulting, mortgages, mergers and acquisitions and the rest of banking’s most lucrative concessions have fallen into a more or less permanent funk, and so the banks are faced with the prospect of earning their money the hard way – i.e., through ruthless cost-cutting, and via fees on checking accounts, credit cards and other transaction-based services.
How dull! Embarrassing, even, since financial bigwigs who were pulling down seven-figure bonuses just a year ago thanks to the Federal Reserve’s extravagant bailout terms, will now be fighting to earn their base pay by nickel-and-diming their customers to death. Imagine a loan officer having to concern himself with something so mundane as a local businessman’s request for money to finance inventory.
We feel sorry for the many bank employees who are about to lose their jobs, especially since they face such bleak prospects for re-employment. With respect to the fate of banking’s top brass, however, it’s going to be hard to hide our schadenfreude if a few of these prodigious paper-shufflers wind up living out of shopping carts. Ditto for securities traders at the big banks, for they have turned the markets into a giant casino, exploiting mathematically arcane opportunities that have absolutely nothng to do with the business of making, buying and selling real things.
In recent years, stock and bond markets have almost completely decoupled from the real economy – so much so that they will probably have to collapse into ruin before honest markets can re-emerge – markets that serve the real commerce of the real world. The epic fraud of financial markets reached its apotheosis with high-frequency trading, a tactic that uses computer-driven algorithms to exploit bid/offer spreads that exist for mere nanoseconds. Because these trades can move no more quickly than the speed of light, it is necessary to execute them on servers that sit on the trading floor rather than on microprocessors associated with distant satellite feeds. How long could that game go on?
by Jeff Clark, Big Gold
Posted July 15, 2011
IN SPITE OF CONSTANT HEADLINES ABOUT DEBTS AND DEFICITS, most Americans don’t really believe the U.S. dollar will collapse. From knowledgeable investors who study the markets to those seemingly too busy to worry about such things, most dismiss the idea of the dollar actually going to zero.
History has a message for us: No fiat currency has lasted forever. Eventually, they all fail.
BMG BullionBars recently published a poster featuring pictures of numerous currencies that have gone bust. Some got there quickly, while others took a century or more. Regardless of how long it took, though, the seductive temptations allowed under a fiat monetary system eventually caught up with these governments, and their currencies went poof!
As you scroll through the 23 banknotes (fiat currencies) below, you’ll see some long-ago casualties. What’s shocking, though, is how many have occurred in our lifetime. You might count how many currencies have failed since you’ve been born. You might suspect this happened only to third world countries. You’d be wrong. There was no discrimination as to the size or perceived stability of a nation’s economy; if the leaders abused their currency, the country paid the price.
So what’s the one word for the “thousand pictures” below? Worthless.
Yugoslavia – 10 billion dinar, 1993
Zaire – 5 million zaires, 1992
Venezuela – 10,000 bolívares, 2002
Ukraine – 10,000 karbovantsiv, 1995
by Charles Hugh Smith
Posted July 22, 2011 on Of Two Minds
The banks of Europe are the new Feudal Manors and Masters. All Europeans now serve them as debt-serfs in one way or another.
IF WE KNOCK DOWN ALL THE FLIMSY SCREENS OF ARTIFICE AND OBSCURING COMPLEXITY, what we see in Europe is a continent of debt-serfs, indentured to the banks under the whip of the European Union and its secular religion, the euro. I know this isn’t the pretty picture presented by the EU Overlords, of a prosperity built not just on debt, but on resolving the problem of debt with more debt, but it is the reality behind the eurozone’s phony facade of economic “freedom.”
What else can we call the stark domination of the big banks other than Neo-Feudalism? In one way or another, every one of the 27-member nations’ citizens are indentured to the big international banks at risk in Europe, most of which are based in Europe.
Amidst the confusing overlay of voices and agendas, there is really only one agenda item: save the big European banks. Everything else is just mechanics. The banks are the new feudal manor houses, the bankers are the new feudal lords, and the politicians of the EU and its influential member nations are the servile vassals who enforce the “rule of law” on the serfs.
Here is the fundamental fact: there are trillions of euros of debt which can never be paid back. In a non-feudal system, one in which the banks were not the Masters, then this fact would be recognized and acted upon: something like 50% of the debt would be written off in one fell swoop, all the banks whose assets had just been wiped out would be declared insolvent and liquidated, the remaining debt would be sized to the economic surplus of each debtor nation, and a new, decentralized banking sector of dozens of strictly limited, smaller banks would be established.
To the degree that is “impossible,” Europe is nothing but a Neo-Feudal Kleptocracy serving its Banker Lords.
The Greek worker whose pay has been slashed in the “austerity” demanded by the banks serves the Banker Lords, as does the German worker who will be paying higher taxes to bail out Germany and France’s Banker Lords. Though the German is constantly told he is bailing out Greece, the truth is Greece is just the conduit: he’s actually bailing out the EU’s Banker Lords.
We can clear up much of the purposeful obfuscation by asking: exactly what tragedy befalls Europe if all the sovereign debt in the EU was wiped off the books? The one and only “tragedy” would be the destruction of the “too big to fail” banks, not just in Europe but around the world. As the big European banks imploded, then their inability to service their counterparty obligations on various derivatives to other big banks would topple those lenders.
While the political vassals call that possibility a catastrophe, it would actually spell freedom for Europe’s 500 million debt serfs. From the lofty heights of the Manor House, then the loss of enormously concentrated power and wealth is indeed a catastrophe for the Lords and their political lackeys. But for the debt-serfs facing generations of servitude for nothing, then the destruction of the banks would be the glorious lifting of tyranny.