Sunday, 23 November 2008

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.


marksany said...

Spot on Mark. Also add in the facts that the gummint has made it clear they'd like the money back one day, and they have demanded that banks increase their capital. Then there is even less chance of the £37bn be used for funding new loans.

Lola said...

In other words is the State our servant or are we the servants of the State?

Arthur said...

Fine explanation as ever, but I have just one point of correction.

You say that banks "don't actually create new money," when this is exactly what do do.

The fractional reserve system, whereby banks lend out proportions of their deposits, injects money into the economy as surely as if the Bank of England printed new sterling notes and put them straight into the hands of Westfield shoppers.

This is at the core of Western Banking models and the rapid expansion of credit is largely to blame for the monetary expansion we have witnessed over the last decade.

Inflation (mostly in housing) is, as I am sure you know, at the root of the financial turmoil we find ourselves in today. Whilst I agree with you that land value taxes would dampen this area, it remains my belief that the fundamental reason for this inflation bubble (and the subsequent crash) is this expansion of the money supply; and it just so happens that it was caused this time by massive increases in credit issued through banking institutions.

Milton Friedman went over this a while back, again as I am sure you know, and explained that it was changes to the amount of money that causes inflation and deflation alike. That the banks can, therefore, so directly influence the amount of money out there through giving credit is of critical importance to our economic well-being.

I am not for one moment contradicting your explanation of why the banks are reluctant to grant credit at the level they were before, but just saying that they do create money in their lending activities and this causes inflation.

AntiCitizenOne said...


It's temporary/virtual money.

If it's paid back or defaulted on it dissipates.

Arthur said...


It does not matter whether credit is temporary or virtual. Once it is in the economy, it has a real effect on prices; it is expanding levels of credit over the last decade that has done more to push house prices up than anything else.

And the defaults are the nightmare scenario. This reduces the level of credit in the economy and, therefore, reduces the amount of money used to buy things. This is what causes deflation.

What MF argued for, after analysing the Great Depression, was a stable money supply: not increasing too rapidly and certainly not decreasing too rapidly. Credit is and always was a major factor in the money supply.

Mark Wadsworth said...

Arthur, agreed that the house price bubble and the credit bubble are two sides of the same coin. But the deflation is now mainly in house prices.

As to keeping house prices low and stable, that's a job for Land-Value-Tax-Man as much as sensible banking supervision (as you pointed out in your first comment).