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We've been looking at how
banks work:
February 17, 2008: How Banks Work
3: More Elephant Poop
February 10,
2008: How Banks Work 2: Shitting Like an Elephant
February 3, 2008:
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.
Right?
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.
* * *
A reader asked a question
via email, and I thought the answer got at some interesting ponts that other
people might also want to think about. This is fairly complex stuff. I
touched on this before, but it's worth chewing over a bit more.
Q: I did some rudimentary
analysis of the monetary base published by the St. Louis Fed and found that
the year – over – year growth rate (of the base) is slowing
rather dramatically. While I don’t think the monetary base per se tells
you much about how the Fed is managing the dollar, it does make me wonder if
they’re on to something, more so than they let on, and being
contradictory to their statements that they are trying to increase liquidity
to help the credit markets. If they are targeting base money, they’re
not reducing the base fast enough given what oil, gold, and the dollar are
telling us.
Can you help me with my analysis?
A: They might be fibbing
about the monetary base numbers. But, let's assume the numbers are correct.
The Fed can't really
target the monetary base, so long as it has an interest rate targeting
mechanism. Maybe they can sort of bend things in a certain direction, but the
rate target will take precedence.
I interpret the low, or
even negative, base money growth as evidence of a rather dramatic decline in
demand for dollars worldwide. The monetary base is about 90% paper bills, and
about 70% of this circulates internationally (perhaps more). If people no
longer wish to hold these dollar bills, preferring euros instead for example
(euro base money has been growing quickly), then the bills tend to end up at
banks, and if banks don't want them (they have no use for them unless someone
comes and takes them off their hands) then they tend to be redeemed at the
Treasury for electronic bank reserves, which are another form of base money.
These electronic reserves are then lent out, which tends to reduce the
interbank lending rate (Fed funds rate), and then the Fed compensates one way
or another by selling some assets (or buying fewer), so that the overall
monetary base contracts or has slow growth.
Thus, rather than a
proactive attempt to support the currency, I see this low base growth as a
symptom of the dollar being used less internationally. Although the
interest-rate targeting mechanism does reduce the base somewhat in response
to this decline in demand, as per the mechanism outlined above, it does not
do so adequately enough to fully support the currency's value. Thus, the
overall result of the decline in demand is a decline in currency value.
That's how I see it. The
relationship between monetary base growth and currency value is a lot looser
than most people think. You can have a very quickly growing monetary base
(Russia for example) with a strong currency, and a low-growth base with a
declining currency (like the dollar). You can see that Russia's monetary base
growth is high because the currency is strong, and
the dollar is weak, and thus people are dumping their dollars and doing
business in rubles instead.
It is fairly typical to
see the monetary base grow rather slowly in inflationary times, in comparison
to the decline in currency value. I used the example of the 1970s, when the
USD base grew about 110% during the decade but the value of the dollar fell
by about a factor of 20, or 95%. When inflation is a problem, then a)
international holders often dump the currency, and b) the opportunity cost
(interest rate) of holding paper currency increases, so people hold less of
it, preferring interest-paying money market accounts etc. for their
"cash". Thus we see in Japan in the 1990s for example decent growth
in the monetary base, as people saw no penalty in holding large amounts of
paper bills vs bank accounts paying 0% with some risk of default.
"Liquidity" as it is popularly imagined, is somewhat different than
the monetary base. Today, the Fed is tending to support the credit functions
of weak banks. Let's say that Countrywide Financial has to borrow from the
Fed because nobody else will lend to it. Thus, the Fed lends $50 billion to
Countrywide (hypothetically). However, this means that someone else doesn't
lend $50 billion to Countrywide, and thus has $50 billion to lend somewhere
else. This tends to depress the interbank rate, and the Fed compensates for
this via its interest rate targeting mechanism. Thus the net addition to the
monetary base might be closer to zero.
There was no
"shortage of liquidity" in the early 1930s. As long as systemwide
funds are adequate (ie interbank interest rates are tolerably low), then
banks have no problem borrowing if their credit is good. Some banks'
credit wasn't good, and nobody would lend to them, and thus they blew up. The
idea was that the Fed would allow banks to make these decisions among
themselves. It was later thought that, in a crisis situation, the Fed should
be more lenient for reasons we can easily imagine, to prevent systemic
failure. In practice, this means the Fed (or other government agency like
today's FHLB) would make direct loans to banks that other banks wouldn't make
loans to. This could be through the discount window, term-auction facility,
or simply via repos with shaky institutions. The Fed is doing all these
things now, providing "liquidity" to banks that would have trouble
borrowing otherwise. (For a bank, it is not just borrowing, but borrowing at
a rate that doesn't result in a negative carry.)
Hope this helps.
* * *
One last thing here,
especially for our college-age readers. Here's the secret of How to Be Right All the
Time.
Are you ready? This is
important.
Admit you are wrong all
the time.
In economics especially,
everyone is wrong a lot of the time. Not only about the future, but also
about the past. I change my mind all the time. I say "I used to think
this, but then this other thing came to my attention, and I thought about it,
and now I think this instead." Nobody cares much. This is the process of
learning. If you keep at it, you might not only learn things that are new to
you personally ... you might learn things that hardly anyone has ever
discovered before. Indeed, so many economists (and other sorts as well) are
so convinced that they must never change their mind, that
they get stuck with some loser idea for decades, or the rest of their life.
They are easy to surpass, because they aren't going anywhere. They got stuck
in the mud in their late 20s. If you keep dropping these old ideas, you will
be so far ahead of everyone else that it will appear to them that you are
right all the time.
Many of you will surpass
me. You will learn everything I know by the age of 30, and then go on from
there. I am looking forward to that.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street Journal
Asia, the Japan Times, Pravda, and other publications. He has appeared on
financial television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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