Friday, 1 November 2013

Deutsche Bundesbank on "Stressed Banks"

Deutsche Bundesbank is out with a short report titled "Before the crisis: stressed banks bid more for central bank money". It answers the question When are banks stressed? as follows,
Stressed banks are unable to refinance themselves via interbank trading. Other banks lose confidence in the solvency of these banks. They either stop lending them money altogether, or charge them high risk premiums. Stressed banks therefore experience liquidity shortfalls. They do not have enough money of their own to meet their liquidity requirements.
Stressed? No, bust is the correct word. If you cannot afford to pay your bills you are per definition bust, or bankrupt.

When non-financial companies (the ones that receive no special favours from governments) do not have enough cash to pay their ongoing bills, they're in fact defaulting on their commitments and is hence insolvent, or bust. Under such circumstances, the non-financial company must negotiate with creditors, speed up payments from debtors and/or increase debt (overdraft, loans, bonds etc) and/or increase equity etc to attain the necessary funds. If none of these options are successfully completed, the company will be put into administration/bankruptcy procedures.

But what happens if a bank is "stressed", i.e. bust? Well, they receive funds from the central bank, which is backed by the tax payer. Result? A bank which should have been allowed to fail is able to continue doing business leading to moral hazard on a grand scale, increases in money supply which reduces the purchasing power of the currency, unfairness (why should a bank survive and not a struggling shoe manufacturer?), misallocation of resources, booms and busts caused by growth of credit unbacked by prior savings (caused by fractional reserve banking), prolonging the malinvestments which distort the market, and many more.

It's time to end this madness by moving to a 100% reserve requirement for banks with no central bank there to save them when they've been mismanaged and imprudently run. 

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