How Banks Work

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We've been looking at how banks work:

Last week, we talked about how credit losses lead to shrinkage of the bank's capital base. Typically, when banks have capital impairment (losses), there is much hue and cry that lending will shrink as a result, leading to recession. This is based on a very simple multiplication: banks typically have about 10:1 leverage. Their assets (mostly loans) are typically about 10x their capital base. So, this simple line of thinking goes, if capital shrinks by 20%, then loans must also shrink by 20% to keep the ratio in line. And indeed, the BIS capital ratio requirements mandate that large banks not get too far out of line regarding these ratios.

Oh my GAAAD! Horror! We're doomed!!!!

But banks don't really work like that. This is a subset of a broader group of theories, that an economy can be managed by a sort of mechanical top-down monetarist approach. The "money multiplier" was another of these ideas, as is the old "MV=PT" theory which actually dates from the 17th century, if not earlier. They are all based on the idea that there is some amount of "money" (or capital), and everyone jumps up and down like puppets depending on this one quantity variable. Thus, if banks have capital, then they create loans according to some sort of inevitable mechanical multiplication function, and if they don't have capital then loans shrink by the same inevitable mechanical multiplication function.

The world doesn't work like this at all. Just think of why borrowers and lenders get together in the first place. The borrower thinks: "If I borrow this money, then I can invest in an asset (or business) that, over time, will produce an effective return on capital greater than the rate of interest on the debt, and I'll make a profit." OK, that's a little technical, but the basic story is that the borrower sees an opportunity to put capital to use. The lender is thinking almost the same thing: "If I lend this money, I can enjoy a return on assets (the interest on the loan, minus credit risk) greater than the interest paid on my borrowing (which is the interest paid to depositors mostly), and thus enjoy a profit." In other words, it's a win-win situation, as it would have to be or nobody would do it voluntarily.

If such win-win situations exist, then the financial system will naturally tend to find a way to make it happen. For example, what if there was a borrower who had some great uses for capital, but had a hard time borrowing? They would look around for a lender, and be willing to pay a decent interest rate. They could look all over the world. They aren't limited to US lenders. (In 2006, I was making some loans to companies in China, while others in the firm were making loans to small companies in Mexico and Venezuela. They paid very well.) The entity that made this loan would probably do pretty well, also. The lender would thus be profitable. Capital chases the profit. Thus more capital would be directed at this sort of lending, and the banking system would expand.

To take a more specific example, what if there were lots of wonderful loan opportunities, but banks today are unable to take advantage of them because of impaired capital? Well, they could then raise some more capital, which is exactly what they are doing. "We need capital to take advantage of this wonderful situation. If you buy an equity stake in our bank, we are sure you will enjoy a wonderful return on equity." Investment floods into the sector. This has been happening in a big way in Eastern Europe, where Western European banks are investing hugely. This is also an argument behind the sovereign wealth funds' recent investments in big US banks. "Well, they're having a hard time now, but they have fantastic franchises and have proven to be very profitable in the past. We'll bet on a winning horse, and when the situation turns around and there are more lending opportunities, the bank will make good money again." Or something like that.

Or, a competitor could arise. "Bank A is flat on its back due to crappy lending in the past. Nobody wants to invest in Bank A because they are such losers. However, Bank A is missing all kinds of wonderful lending opportunities as a result. I'll step in and eat Bank A's lunch! And you can join me, just invest in my new bank." Warren Buffet is doing something like this by challenging the monoline insurers' core municipal bond insurance business. Thus the total capital of the system increases, in response to the excellent returns on capital provided by the abundance of win-win lending opportunities.

To summarize, lending is not driven by capital, rather capital is driven by opportunities in the lending business. Probably every businessman understands this, as it is true not only of banks but of practically any industry.

A good example of this appeared in Japan. In the 1990s, we were hearing the same baloney about how banks couldn't lend because they didn't have enough capital, and if there was more capital, then banks would lend more, and the economy would recover. There was a major failed bank called Long Term Credit Bank of Japan. The government thought it would use this bank as an experiment. They effectively nationalized the bank and sold it to some foreign (US mostly) investors, who effectively made a new bank out of it. (The new bank is called Shinsei Bank, which means "New Life". Poetic bank names were very popular in the 1990s in Japan.) Now there was a brand-new fully-capitalized bank without all the bad-loan difficulties of the other major banks. Plus, this brand-new bank had (supposedly) best-quality management, namely those New York sharpies who were going to show us all the most sophisticated pratices in the financial industry. This new bank would then make all the loans that the other banks "couldn't" make, because they were capital impaired. With more loans, the economy would recover.


Wrong. Actually, at the time, there was very little demand for borrowing, because of the poor economy. The poor economy was caused, in large part, by monetary instability in the form of horrible deflation, plus various tax hikes. Debt is very painful in a monetary deflation. Most of the healthier companies had all the debt they wanted, and more, and didn't see many expansion opportunities (requiring more borrowing) in the environment of unstable money and high taxes. Most of the weaker companies nobody wanted to lend to, nor did they want to borrow either, as they were spending all their time trying to figure out ways to escape the burden of their past debts. In fact, the existing large banks were, at the time, searching very hard for good lending opportunities, from which they could make the profit to pay for their losses on their existing bad debts, and not finding many. All of this was represented in very low interest rates (high prices), for both government and good-quality corporate debt, which shows an excess of buyers (lenders) compared to sellers (borrowers).

So, what happened to Shinsei Bank? For the first couple years, it didn't do a thing. The lending market was, in fact, very competitive, and virtually all the demand for debt was satisfied at very good prices for the borrower (low interest rates), and rather poor terms for the lender (narrow net interest margin and low profitability). Later on, as the monetary issue was resolved (reflation), investment opportunities arose again, and both banks and borrowers got together to take advantage of them.

The New York sharpies still made out very well, however, mostly because of cushy terms given to them from the government. So, in the end, the real opportunity was not in the wonderful lending opportunities. The real opportunity was the chance to get a very cushy deal from the Japanese government. And how did they get this cushy deal? Because of the idea that there would be some wonderful lending boom and economic recovery if the government gave them a cushy deal.

That is one reason why we see these arguments again and again during these "bad debt" events. The economists at the big brokerage houses blah blah about it constantly. Some of the economists are aware of the scam (a little bit), but most are just useful idiots. At the end of the day, they act like amoebas that swim toward a source of sugar. (If they weren't idiots, they wouldn't be useful.) The useful idiots understand, at some limbic level, that if they talk the blah blah, they keep getting paid. The journalists pick up on it and magnify it. (Most journalists have an inferiority complex, making them unwilling to challenge anyone who makes more than they do, which is about everybody, and amount to badly paid useful idiots.) After years and years of this blah blah, the politicians relent.

Probably the scammers themselves (in this case the foreign investors) believe the story. Why not? They aren't economists either, but they can smell a good deal, and if they can also Play an Important Part in the Revival of the Japanese Financial System, well, that's fine too, and maybe they'll get an honorary degree or something out of it.

And who is pushing this idea today? Why, it's the economists of Goldman Sachs! I am soooo surprised!

$2 trillion lending crunch seen Goldman Sachs economist says mounting credit losses could force banks to significantly scale back their lending.

Are we prepping the waters here for another cushy deal from the government? Maybe? It might be a different sort of cushy deal. More like a "save our asses by taking our bad debt off our hands, or lending will contract by $2 trillion!!!" cushy deal.

Bank of America Asks Congress for a $739 Billion Bank Bailout

Well, that's enough for this week. We are going to be talking about banks around here for a while longer, I can tell.

Nathan Lewis is the author of Gold: The Monetary Polaris (2013), and Gold: The Once and Future Money (2007).  

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