How Banks Work 4: Banks and the Economy

How Banks Work 4: Banks and the Economy

February 24, 2008


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.


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.

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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?

How Banks Work 4: Banks and the Economy

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.

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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.