Wednesday, 15 April 2015

Why Norwegian Banks Will Be Bailed Out

Yesterday, Norges Bank, the central bank of Norway, published a speech by its deputy governor Jon Nicolaisen titled "Should banks be bailed out?". 

In the speech, Nicolaisen discusses among other things why banks are bailed out in addition to discussing various reasons why they should not. At the end of the speech under the heading "What should be done?", he concludes as follows:
So what are the lessons we have drawn?
Banks should not be bailed out, but banks' functions must be bailed out. If not, all economic activity will be affected. We will bail out the small depositors – that is both profitable and fair.
We should not bail out all creditors. If the equity capital in bank is lost, long-term lenders should also bear losses. The new tools that have now been introduced in Europe will ensure that this happens. Norwegian legislation must be updated in line with the new directive. This will improve the pricing of risk in the banking system.
We will not bail out the shareholders. Ultimately, bank owners and management must ensure that banks are run prudently. It is crucial that they are aware of their responsibilities. We cannot regulate banks to death. I am confident that owners and managers of Norwegian banks will act responsibly.
At the same time, banks must be regulated. Capital requirements must be high and we must ensure that banks are solid and well-run. This will reduce the risk of a systemic crisis. This will also give banks' owners a stronger motive to take account of long-term risk. Banks themselves and Finanstilsynet (Financial Supervisory Authority of Norway) have done a good job to ensure a solid Norwegian banking sector, so that the authorities avoid having to bail out banks.
In many ways, the speech is very informative, though the debate about whether banks should be bailed out should be laid dead. Like for any other business, bank losses should not be socialised while profits are not.

The speech however fails to address the underlying problem of why banks frequently run into financial problems in the first place: their ability to lend money into existence. In this respect, he is incorrect when stating that "Banks may be regarded as intermediaries". They are not. A true intermediary would lend out only what others have saved. This is not the case for banks in the world today, including Norwegian banks. Instead, banks create a deposit liability when granting a loan thereby creating new money in the process - this is what is meant by "creating money out of thin air". 

Banks privileged ability to create new money is the primary reason the money supply in Norway has surged from less than NOK527 billion in December 1995 to more than NOK1.9 trillion as of February this year - an increase of almost 261% in less than 20 years! 

These very deposits created out of nothing can again be used to extend further loans. This is perhaps what Nicolaisen had in mind when suggesting banks "may be regarded as intermediaries". Again, a true financial intermediary don't create new money when lending what others have saved. There is a big difference between the two, a difference also bankers regularly fail to see or to understand if they do see it. According to numbers today released by Statistics Norway, banks in the country now finance 87.5% of their customer loans (which excludes financial institutions) with these kinds of deposits. 

If we add the deposits from and loans to financial institutions, the ratio increases to 90.5% as of February. The two ratios demonstrate that the majority of the loans issued by banks are financed with the very deposits the banks themselves created in the first place. It works like a gigantic Ponzi scheme as new loans are largely financed by deposits created from nothing at an earlier stage. However, it's much more sinister as it affects all and not just the hopeful speculators taking part (aware or not) in a Ponzi scheme. 

What about equity financing? The painful truth is that it is largely nonexistent as a source of bank financing in Norway. In the U.S., banks finance around 10.8% of their total assets with equity capital, an extremely low percentage compared to non-bank businesses. For Norwegian banks, this figure is currently an eye-opening 6.9%! 

As the market values of bank assets fluctuate with time and as bank liabilities are largely fixed (as deposits, i.e. cash liabilities, make up more than 70% of total liabilities), banks' equity capital could be wiped out if the value of assets drop by just 6.9%. Such a drop should not be viewed as an unlikely scenario. On this note, we should acknowledge that house prices can go down as well. "Financial stability is one of Norges Bank's primary objectives in its efforts to ensure economic stability" according to its website. Then why in the world doesn't it do anything about the shamefully low equity financing for Norwegian banks, the very source of "systemic risk" combined with banks ability to create money out of thin air? A marginal "capital buffer" will not do the trick. Nor will an equity to total assets ratio similar to that in the U.S. do the trick. 

In conclusion, the bank bailout debate continues unabated despite the 2008 banking crisis in the U.S. and Europe. The debate continues because the fundamental causes of bank instability, and with it economic instability, namely banks ability to create money out of thin air and low equity capital financing made possible through Norges Bank as the lender of last resort, are not being addressed other than paying lip service to marginally higher capital ratios. Nicolaisen's speech is therefore largely irrelevant as, given the poor state of Norwegian banks, Norges Bank will provide liquidity to the banks again next time around just as it did in 2008 and 2009. This per definition constitutes a bailout. 

"Central banks have traditionally acted as lender of last resort (LLR). This means that when liquidity demands cannot be met from other sources, the central bank can provide extraordinary liquidity to individual banks or the wider banking system."

Meanwhile, Norwegian banks continue to fuel further "imbalances" and "systemic risk" as the money printing presses are running hot...

...creating the very vicious cycle Norges Bank and regulators are supposed to protect the country against. What an irony.

With such reckless monetary expansion orchestrated by Norges Bank and blessed by the Norwegian government, vastly outpacing the amount of gold dug up, there is little wonder the Norwegian Krone (the local currency) has lost more than 97% of its value against gold since 1971.

For more on Norwegian banks also see: 

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