Bank bail-outs for beginners

The Goblin King, The Badger and The Prince of Darkness have all been on record in the past couple of days, wringing their hands about the fact that UK banks aren't doing what the government wants them to do (which is to prop up house prices via more reckless mortgage lending and, to a lesser extent, not pull the rug from under businesses), despite the massive taxpayer-funded bail out.

So, for the benefit of these senior government figures, here's my Noddy's Guide on How Banking Works.

1. In normal circumstances, money comes in from depositors, bondholders and shareholders ('investors'), the bank records this as liabilities and lends it out to mortgage borrowers and businesses ('borrowers') and records these advances as assets (banks are just middlemen, of course, they don't actually create new money - see footnote*). The bank receives repayments of interest and capital from the borrowers ('income'), and after deducting running expenses, the income is passed on to the investors as interest, dividends, bond redemptions and share buy backs ('expenses'). As long as there's confidence that house prices will continue rising, in the economy and in the bank, this all hums along quite smoothly:


2. Until one day, confidence in ever rising property prices and debt-financed businesses starts to erode; banks are less willing to lend, the value of the bank's assets (i.e. loans to borrowers) starts to look shaky, and these borrowers start running up arrears. In this case, the arrow from the investors flips round - they want their money back; or at least, they want to shift it from higher risk to lower risk investments in banks (from bonds to deposit accounts, for example) or from higher risk to lower risk banks. This now becomes the bank's most pressing concern - how to keep their creditors (the investors) off their backs before they start a run on the bank:


3. "Oh dear," thinks the government, "The whole property price bubble, on which the illusion of ever rising wealth was based is bursting, and less-well capitalised businesses are going to the wall. Let's fire hose £37 billion of taxpayers' finest at the banks!"

The Big Fat Arrow in the last picture represents the £37 billion (with promises of plenty more to come):


4. Now, in the name of All That Is Unholy, who in their right mind expects banks to do anything other than hoard that cash to cover withdrawals from deposit accounts, to keep up interest payments and redemptions on bonds, maybe even to continue to paying dividends, to send a false signal that the bank is still profitable?

FFS, is the government really surprised that the semi-nationalised banks aren't all too keen to continue granting mortgages secured on plummeting property values?

As an unfortunate result of all this, debt-financed businesses (who may be otherwise well run and profitable) are going to the wall, which of course exacerbates the down turn, but do not imagine for one second that the government gives a hoot. Businesses are merely there to bid for government contracts (i.e. make donations to whichever party is in government), to pay as much tax as can be milked out of them and to create jobs for regulators.

* This statement is hotly disputed, for example see Arthur in the comments. I agree that banks can create loans apparently out of thin air, but you must always remember that for every £1 they lend to borrowers they need to receive another £1 from investors. So the result of a credit bubble is that a lot of borrowers end up owing a lot of investors a load of money, but the banks are just middlemen - the bank's net asset position does not change by one penny as a result.