meet your banking buddies...
We have already met commercial banks in the last lesson and how they earn profits by lending out depositors’ money. Here is another piece of the jigsaw which will link to our understanding of money. But first we need to look at a history of banking before discovering more about the way banks are organized today. All financial institutions and commercial entities need to record their transactions in books of account using the double-entry system: ‘debit’ and ‘credit’. We have already encountered these terms in the last lesson. Before we explore the banking system it is worth taking a brief look at how debit and credit works because unless you are a trained accountant it is likely that these terms will add further confusion to an already complicated subject. There are two main documents used in financial reporting:
1. The Profit & Loss account, which lists total income and by deducting total expenses reveals net income: ‘profit’ or ‘loss’
2. The Balance Sheet upon which first, are listed all the ‘assets’ – such as: equipment, land, and money owed to the business (debtors), plus cash at bank and investments; and second listing all the ‘liabilities’ – such as: loans made to the enterprise, money owed to suppliers (creditors), any overdraft/loans at the bank, and investments made into the business such as ordinary shares
From the balance sheet we see total liabilities (they are all the creditors added up) and we take them away from the total assets (these are all the debtors) and arrive at a positive result (a solvent business) or a negative figure indicating that it is in trouble because it owes more that it owns. The balance sheet is but a snap-shot of the health of an enterprise at any one time. A simple way to remember debits and credits is to think of them as:
Debits are either assets on the balance sheet or expenses in the P&L account
Credits are either liabilities on the balance sheet or income in the P&L account
Double entry bookkeeping works by making two entries for each single transaction, which always equal each other, and gives rise to the expression: “balancing the books”. Banks use the same system, but to add confusion, your bank statement shows the reverse of what is expected. We are said to be in ‘credit’ when we have money in the bank, however at first sight, we would expect this to be an ‘asset’ as it is our money in the bank! Quite so, and you can be forgiven for thinking this, as most people do. There is an answer.
Your bank statement is a copy of your account, but in the bank’s books, it is telling you that your money is a liability (creditor) on the bank’s balance sheet, (see above) – and therefore it is not your money anymore, it is owed to you by the bank; the bank has become your debtor. So where is the equivalent debit? Put simply, it is in your books, it is a debit, and therefore it is your asset, being your money in the bank. In pure accounting terms cash in the bank should strictly be shown in your books as a debtor, the bank owe you the money; as we have discovered you can’t always rely on getting it back!
Banking as we know it today began many centuries ago when money started to be used in the form of paper notes. At first it was a very local affair with small banks issuing their bank notes to be used by merchants and others in their locality. For example, we still have Scottish bank notes which are a hangover from these earlier times. It soon became clear that competing local banks were becoming unmanageable as some went bankrupt because of too many bad debts and their depositors lost money. This reduced the public’s confidence in banks and encouraged cash trading and bartering, which of course is not easily traceable and the government suffered loss of tax; this situation persists in business and alternative markets to this day!
Every economy needs money to invest for the future and develop new products and services; the more the economy grows, the more money is provided but not simply by printing extra pieces of paper. The clever bankers devised a cunning system to multiply the amount of money in circulation, without cost, by expanding the money supply. They created a system which is known as ‘fractional reserve banking’. You will remember, in the last lesson, that banks take in deposits from their customers as savings and current account balances and we also know that this legally belongs to the bank so they have every reason to lend it out, for profit. In theory the banks are restricted, by regulations, to lending up to 90% of their deposit amounts; keeping 10% as a ‘reserve’ to meet repayments as and when required. However the banking community has developed various ways around these regulations by borrowing money on their own account from other financial institutions which is just one of the causes of the many past financial crises.
For example, say; a 1,000 deposited into one bank allows 900 to be loaned out in the first place and which is eventually re-deposited back into another bank at some point. This allows 90% of the 900 to be lent out again, and so on until the balance is zero, ten times later, (you do the math). By the magic of fractional reserve banking we have created 10,000 worth of loans, out of nothing, for only a single 1,000 deposit. This system of banking is used by countries worldwide and the central bank (or other monetary authority) controls the level of money creation that can occur in the commercial banking system and helps ensure that banks have enough funds to meet demand for withdrawals during normal times.
A problem arises for bankers in that money is loaned out often over a period of several years, but the deposits are only short term, which creates an imbalance between deposits and loans; the bank makes its profit through the interest rate differences. However, if confidence in the banking system fails, and many of the depositors demand their money back at the same time, we say that a bank-run has occurred because the bank is unable to repay its depositors; it would have to declare bankruptcy. One of the central bank’s functions is to allow a commercial bank to borrow funds to fill this gap; this is known as ‘liquidity support’, the central bank acting as lender of last resort. Bank runs can occur for many reasons but are mainly due to a lack of confidence for one reason or another.
In the classic example of Northern Rock, which was the first bank in 150 years in the UK to suffer this fate, the bank run was caused by lending out much more than just 90% of its deposits using a range of complex financial instruments.
Northern Rock had borrowed heavily on its own account in the international money markets, extending mortgages (many failed to repay) to customers, based on this borrowed money and then re-selling these mortgages on international capital markets, in a process known as securitization (more about this in the Financial Engineering Lesson). In August 2007, when global demand from investors to buy these ‘securitized mortgages’ fell away it meant that Northern Rock was unable to repay their loans from the money markets which had provided the funds.
This problem had been anticipated by the financial markets to which it drew greater attention. On 14 September 2007, the bank sought and received loans from the Bank of England (the central bank acting as lender of last resort) to repay the money markets. The widespread publicity and general nervousness led to panic among individual depositors, who feared that their savings might not be available should Northern Rock become bankrupt. The depositors lined up outside the bank to withdraw their savings as quickly as possible but by this time it was too late to rescue the bank which had failed to find a commercial buyer for the business. It was taken into public ownership in 2008, and was then bought by Virgin Money in 2012. This later became the first of several bailouts around the world using taxpayers’ money.
The Northern Rock case is also interesting because it was first a building society, a mutual society bank, where the depositors are actually the owners of the bank and is not involved in the risks of fractional reserve banking. During the 1980s, when Margaret Thatcher’s government embarked on its policy of ‘general privatization,’ Northern Rock, in common with many other mutual societies decided to become demutualized. In the 1990s, along with many other UK building societies, Northern Rock chose to list their shares on the London stock exchange. Throughout this period a concern against demutualization was that the assets of a mutual or building society were built up by its members throughout its history, not just by current members, and that demutualization was a betrayal of the community that these societies were created to serve. Debate still rages today as to the whether these policies have contributed to the continuing financial crises and that perhaps the sound banking principles of yesteryear should have remained a preferred option.
Cyprus would also have been an example of a bank run which in this case didn’t happen. It would have happened if the Troika had not stepped in to ensure that severe restrictions were placed on taking money out of the banks (capital controls) as discussed in the Preface. There is considerable disagreement over the significance of the Cyprus crisis. Some people say that it was just temporary and will not affect the rest of the financial system. Others speculate that it is indeed significant and illustrates what is really going on in the EU and the financial world in general and why our money is at so much more risk than ever before.
However, Cyprus could have been a spark that ignited a keg of dynamite under the financial system. Banks around the world are potentially bankrupt and have been so for years. This is because all the world’s financial systems use fractional reserve banking which, through regulation and backed by government guarantees, only have to keep a tiny fraction of the money deposits on hand. They lend out the vast bulk of these deposits (and often more), so that even in good times they are unable to return on demand all the depositors’ money. The banks’ own loans cannot be called in instantaneously as they are contracted over periods of years and most borrowers would default anyway if the loans were suddenly called in. In bad times this charade is even greater because so many more loans that the banks have made are likely to become ‘bad’ never to be repaid.
Cyprus has demonstrated that governments and bankers are quite willing and able to confiscate our money in their banks in order to preserve their banking system. Cyprus is said to be particularly vulnerable because of its strong financial connections to Greece; Cypriot banks had bought large amounts of Greek government debt. All banks are now beholden to the state because they own so many government bonds, which are considered to be the most secure, but which is quite the opposite in reality. Many governments themselves are bankrupt and the Greek government is among one of the worst of them all.
Historically, commercial banks offered two types of accounts: demand deposits and time deposits. Demand deposits are what we now call current accounts, but the original idea was that you would pay your bank to store your money securely, and you had the right to “demand” your deposit back immediately and/or transfer funds by writing cheques or drawing cash to pay bills. Time deposits, which have become known as savings accounts, pay interest when you deposit your money for a specific period of time. This is why they are called “time” deposits; you lend the bank money for a given time period and banks then know how much money they have to lend out at higher interest rates and make their profit.
In the past there was no need for government guarantees on deposits because bankers backed their businesses with their own funds, and if they miscalculated, they became personally liable and often went bankrupt. Depositors would naturally avoid banks which were known to make risky loans and banks competed to be the most prudent and solvent lenders. Both lenders and depositors were cautious in those days. It could be said that the idea of governments guaranteeing everyone’s deposits is just another unaffordable, un-backed social promise of the 21st century. The fact that a government guarantee is now required must say something about the unstable nature of our 21st century banking systems. Unfortunately the real nature of banking is not something taught in schools and colleges but which actually should be high on the curriculum of any secondary educational institution.
Part of the problem is that banks are no longer financed by the individuals who founded them by risking their own personal net worth. Now all banks are public corporations of immense proportions as are most connected financial institutions. This means that they have ‘limited liability’ and are therefore risking, not their own money, but other people’s money – your money – (shareholders’ and creditors’ money) without having to account personally for the consequences of failure. In this event they can just pack up, take their bonuses, cash in their share options and move on. Government guarantees create what is known today as ‘moral hazard’ where risk is not borne by the risk-taker but is passed from the banks to their shareholders and creditors (depositors), without recourse, and thus the taxpayer has to pick up the final bill.
Yes, this means YOU pay their bill with your taxes. Wouldn't it be great to keep all the winnings but put your losses on others too?
Just imagine that you are a smart, young trader working for Barclays, Goldman Sachs, Deutsche Bank or any one of these mammoth financial institutions in the City of London or Manhattan. It’s actually in your best interest to make irresponsible bets. You could win millions of pounds on this financial roulette wheel if you win and get a multimillion bonus. One really cannot blame these people; it is the financial system itself that is failing, as there is little incentive for banks, governments or politicians to change because they are the ultimate beneficiaries. Only a cataclysmic failure will initiate the needed changes but unfortunately we will all have to pay the price when this happens.
Nevertheless, you can be sure that the financial elite will be long gone when the crunch arrives, as has already happened in Cyprus. Yet again the wealthy had flown the banks with their money well in advance and, as was reported on 13th April 2013, the Cyprus government found out they lacked the funds to continue with the bail-in process. They estimate that their banks now need 23 billion, and not the 17 billion originally planned because of shortfalls in the projected amount of deposit money left available. This is an example of how difficult it is to prevent the smart money moving before emergency controls can be implemented.
Thus far we have been discussing commercial banking which deals mainly with facilitating merchants and international trade; offering their customers easy ways to receive income and pay bills; granting credit facilities to smaller businesses, credit cards and savings accounts for the general public. This is only one part of banking services in general; the larger part (by value) is involved with ‘investment banking’. These types of banks provide investment services to major companies and high net-worth individuals as well as ‘trading’ (speculating) with other people’s money on their own account and known as proprietary trading. In the eighteenth century these investment/merchant banks provided money to companies in the form of shares (known as equity) as well as arranging large loans against acceptable securities. These banks also provided advice and investment guidance on corporate matters to the firms to which they would lend.
There is an important distinction between commercial and investment banking which was recognized, following the Great Depression in the 1930s, as being a significant contribution to its cause. Many economists also suggest that the crisis in 2008 was made much worse because of commercial and investment banks activities having been merged since 1999, allowing excess speculation (gambling) using our money (depositors) which was never the intention of established commercial banking practice. There was a good reason how this came about, which is very important to understand, as it highlights the depth to which bankers have descended recently in taking over lawmakers, mainstream media and government for their own selfish interests. This piece of the jigsaw is crucial to obtain a true picture of the global financial system and which affects each one of us every day.
The Great Depression was a severe worldwide economic downturn which began in 1930 and lasted into the late 1930s to the middle 1940s. It was the longest, most widespread, and deepest depression of the 20th century. The Glass–Steagall Act was passed in the USA to assist in the prevention of a recurrence of economic depressions among other measures. It is most often used to refer to four provisions of the U.S.A. Banking Act of 1933 that limited commercial bank operations and affiliations between commercial banks and investment banks and aimed at preventing risky speculation with depositors’ money.
In the 21st century, the Great Depression is commonly used as an example of how far the world’s economy could decline. The depression originated in the U.S.A. after the fall in stock prices which began in September 1929 and became a crash in October 1929. International trade plunged by more than 50%. Unemployment in the U.S.A. rose to 25% and in some countries rose to as high as 33%; not unlike economic conditions today if the true statistics were ever published.
See an example from John Williams of Shadow Government Statistics [SGS]: he publishes alternate data which more realistically reflect the true economic situation in U.S.A. and, as can be seen from the chart, unemployment in USA is approaching levels today equivalent to those reported during the Great Depression. This also shows how governments distort official data to avoid accountability and public outrage. The mainstream media, which have been reduced to mere unthinking mouthpieces of government policy, mainly report only the government versions.
The Glass–Steagall Act held firm until 1999 when the financial elite ‘powers-that-be’, after constant lobbying, managed to have it revoked, freeing investment banks to speculate and gamble with depositors’ money as well as to have the support of the central banks in case of failure. This demonstrates the sheer, raw power exercised by these so-called ‘masters of the financial universe’ to the detriment of all peoples of the world. These facts are rarely acknowledged in the popular press and therefore people are left only to wonder at the sorry state to which global economics has become degraded. Even leading economists rarely agree as to the remedies to be adopted in order to return economies to a stable and sustaining growth pattern; they are as confused as the politicians and their supporters.
In an effort to apply corrective measures the Dodd–Frank Wall Street Reform and Consumer Protection Act was introduced in America by President Obama in July 2010. As with other major financial reforms a variety of critics have attacked this law, some arguing it was not enough to prevent another financial crisis, others mainly the private bankers, arguing it went too far and unduly restricted the free operation of financial institutions and particularly that of investment banks. The global debate about regulating banks centers on stabilizing financial systems and encouraging growth in economies around the world. Banks are at the core of these initiatives as without them international trade, and therefore growth, cannot recover.
It may well be that the rise in debt during this decade is a consequence, rather than a cause, of the growth slowdown. However, the reason for the crisis nonetheless lies in too great accumulation of debt during the boom years. Economies follow a natural cycle of growth and contractions during periods of approximately 8-12 years. Economic theory requires that during periods of growth debt levels should reduce allowing governments to apply increased borrowings (government debt) during periods of contraction to support their economies in lean times.
In a proposed 2013 supplement to the Dodd-Frank solution, the ‘Brown-Vitter Bill’ offers a different and possibly more elegant solution by extending the Dodd–Frank Wall Street Reform provisions. Rather than impose arbitrary size limits, it simply insists that banks with over $500 billion in ‘assets’ maintain higher capital reserves than are currently required. Giant investment banks such as J.P. Morgan Chase, Wells Fargo, Morgan Stanley, Goldman Sachs, Citigroup and Bank of America will have to have capital reserves of about 15 percent which is about twice normal reserve limits.
The bill has tough limitations but for only the largest twenty ‘mega banks’ which control 95% of the market. The aim is to reduce the risk these banks are taking and to improve overall stability in the markets. The biggest U.S. banks enjoy a massive inherent market advantage; they are able to borrow money much cheaper than other banks because everybody knows the government will never let them fail and are otherwise known as ‘Too Big To Fail’ (TBTF). A precedent was set in 2008 whereby the TBTF banks will always be bailed out in a crisis which makes their debt essentially U.S. government guaranteed. Studies have shown that these banks borrow money at about 1% less than other banks and that this implicit government subsidy is worth about USD85Bn a year for just the top ten mega banks in America. This bill would essentially wipe out that hidden subsidy and make these banks ‘bailout-proof’, at least in theory. After the many recent banking scandals, for example: J.P. Morgan’s $6Bn sudden trading loss in 2012 (do a search for ‘London Whale’ to be blown away!), the LIBOR scandal (where all the major banks rigged the interest rate for everybody’s mortgages for years and got a slap on the wrist), the outrageous HSBC money laundering settlement (search for ‘HSBC money laundering’ and make sure you’re sitting down), and nearly five years of rapacious market-dominating behavior by these state-backed banks, the general community of banks have finally come together to support more effective regulation.
The Financial Crisis Inquiry Commission (FCIC) was set up to discover the root causes of the 2008 financial crisis. In its final report it placed blame for the crisis squarely on the investment banks and the credit rating agencies, (see Lesson 3). The FCIC said: “The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. This crisis could not have happened without the rating agencies.”
Commercial and investment banks form the core of the banking community but are supplemented with a range of specialist financial institutions, known as non-bank financial institutions which provide vital financial services. Insurance and pensions companies are a large component together with mortgage banks, savings banks, credit unions and many smaller, specialized operators. These organizations are not main-stream bankers and do not generally become involved in speculation and financial market activities but rather offer prudent management of peoples’ money and hopefully grow investments to at least keep pace with inflation.
In this decade central banks have kept interest rates artificially lower than markets would normally set in the hope that companies will borrow and invest and increase production as well as consumers being encouraged to spend more and stimulate the economy. However the banks have not cooperated and instead of loosening lending standards they have tighten their policies which is contributing to a general slow-down in economic activity across the globe. Without the banks and their ability to lend, as we have seen, there can be little economic growth and it does seem that the coming decades are destined to become a period of slow or no growth which will have repercussions upon both our commercial and personal lives.