Tuesday, 31 October 2017

Some Fundamental Reasons For Bank Failures

Source: Activist Post

At the end of the 1990s and early 2000s we had the dot-com and telecom bubbles. Not long thereafter we had the housing bubble. To many, these bubbles might be viewed as totally separate and unrelated events that had nothing in common other than being bubbles. However, these (and most other major bubbles during the last hundred years in the U.S. and many other countries) all had two things in common. Firstly, they all popped. Secondly, there was one major player that could always be found in the centre of all these booms and busts; the banking system. 

The banking system, with the elastic money supply it imposes on the market, backed by the support of elected politicians and the ignorance of voters, ensures the economy finds itself almost continually in a state of crisis. Domestic- and cross-border crises meetings, ever new regulations imposed on banks and the finance industry, bail-outs, bail-ins, and state (partial) takeovers of banks and non-banks, are all evidence of economies in a situation of more or less crisis. The larger the degree of socialism (combined with an elastic money supply – a major tool for central planning distributions and re-distributions of money and income) the bigger the risk an economy will find itself permanently in recession.

Banks regularly run into financial problems not by some fault of the free market or by coincidence, but by political design. Fractional reserve banking is inherently unsound and can best perhaps be likened to that of a house of cards or a Ponzi scheme. While sound money is valuable in other uses as well, today’s fiat money has no intrinsic value whatsoever. We here arrive at a key problem that is overlooked by the supporters of the money employed today, namely that the value of the bank assets which are supposed to “back” today’s money are not only themselves dependent on the continued existence of fiat money, but also on a continual increase in the quantity of them

To grasp this important flaw of the money employed today consider a mortgage loan secured by the property the borrower buys with the loan granted. Whenever mortgage lending increases, this will help to push house prices higher. The difference between property market prices and the book values of loans increases as a result. Both banks and borrowers benefit as the value of the collateral now more than covers the loan while borrowers’ equity position improves similarly. The more new money that’s lent into existence into the housing market the better the financial position of already existing mortgages will be for both banks and borrowers. Whenever the quantity of money chasing houses outpaces the number of houses for sale, prices are likely to continue to rise. The issuance of mortgage loans serves to increase the former, a key component determining the marginal demand for housing. We can now see how fractional reserve banking can be likened to a house of cards: house prices and the monetary value of the collateral are determined to a large extent by the increase in the issuance of the mortgage loans themselves which are created out of thin air! 

Likewise, as continuous successful mortgage lending from a banking point of view is dependent on ever more money flooding into the property sector and ever-rising property prices, mortgage lending have the features of a Ponzi scheme. One difference between the two is that savings (already existing money) are usually employed in a Ponzi scheme, while newly created money is employed in mortgage lending. Unless of course the scheme leads to large-scale wasting of resources, Ponzi schemes, no matter how big, could never create a financial crisis like mortgage lending can. When the loan growth ends, or slows down, the marginal demand for housing will decrease and prices will fall unless offset by other factors (e.g. foreign buyers bidding prices up). Many house owners will now find themselves “underwater” as the drop in market values fall below the balance of the mortgages. Banks’ collateral position takes a hit and delinquencies might increase. A relevant proportion of borrowers might later default partly or completely on mortgage payments. Whenever banks then foreclose on a portion of the mortgages they will, especially on the later loans granted, discover that the market value of houses foreclosed on are lower than the loans outstanding. It now becomes evident that the mortgages was backed by little other than the fiat money that themselves were issued from, and backed by, absolutely nothing. The house of card crumbles. The 2006/07 to 2008/09 banking crisis is a staggering example of how fragile mortgage lending can indeed be. A final feature of mortgage lending worth mentioning is that banks end up with a claim on a real asset in exchange for money created out of nowhere with no previous sacrifice.

The fragility of the fractional reserve design manifests itself in two main areas for the banks: 1) only a small fraction of deposits are kept as reserves, and 2) long term assets (loans) are largely financed by short term debt (deposits). Any provocation of either one of the two will swiftly reveal the underlying financial weakness at a bank. The inherent illiquidity of a bank will become evident once a large enough proportion of depositors attempt to withdraw their funds as would be the case during a classic bank run (customers run to the bank to withdraw cash) or during an electronic bank run (when customers transfer their deposits electronically to another bank). The duration mismatch between bank assets and liabilities also presents ongoing challenges in addition to the risk of a bank run. Firstly, the market value of bank assets fluctuates while its liabilities are largely fixed and redeemable at par. A fall in the value of assets can therefore wipe out a bank’s equity. Secondly, a significant portion of the assets are fairly illiquid and hence cannot be quickly converted to cash should the need arise. 

The inherent lack of bank liquidity is not caused by rogue bank management, but is instead a direct reflection of an accounting entry and how the banking system actually is designed: when a loan is issued, the bank records on its balance sheet an asset (the loan, which is typically longer term) and a liability (the deposit, which the borrower can withdraw at any time). The duration mismatch is therefore created at the onset. 

Combined, these balance sheet weaknesses mean banks are constantly at the mercy of depositors and lenders. Furthermore, banks are ever-dependent on market confidence, economic stability, and, ideally, rising prices which the banks themselves help create through bank credit growth. But, as banks are the creators of the boom and bust culture which breeds economic instability, it should be obvious why banks always find themselves at the epicenter of financial crises – all financial crises originates within the banking sector itself. That’s why all financial crises are in fact banking crises.

Related: The "Austrian" Theory of the Business Cycle

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