Banks Play the Music in the Economic Game of Musical Chairs

The history of banking shouldn’t make for bedtime reading. But the whole story is such a scam it reads like the most breathtaking heist in history.

That’s because banks create credit out of nothing. Then they charge us interest for the privilege of getting it. Everything they do from that point on is to keep the shell game going.

It sure puts the debate about how much capital Australian banks should hold in an interesting light. Here’s the recent news: The banks are coming under pressure to raise capital (money) to offset against their loan books.

This is the view of those who think higher capital ratios will put the banks in a stronger position if a big downturn hits the economy. The Australian Financial Review reported this morning that:

Banks should do their bit and raise equity to lower the risks to the economy posed by a toppy property market and overextended households, the local head of giant bond manager PIMCO says.

‘The opinion comes as UBS analysts warn that continued strength in property prices would increase the banking sector’s vulnerability to an economic shock and strengthen the case for further regulatory intervention.’

Sounds comforting to read. But don’t believe it. Even if the banks do raise the money, it won’t prevent the cyclical boom bust nature of the economy.

You don’t have to believe me. I have a book on my desk, Where Does Money Come From?, co-authored by banking expert Richard Werner. It has a whole chapter on why capital adequacies don’t work.

We’ll get to why that is in a sec. First we need to make a quick tour to get the historical irony of all this. The requirement for banks to hold a certain level of capital came about in the 1980s under the original ‘Basel Accords’.

A bank holds capital to cover loans that go into default. But an individual bank can put an indirect limit on the amount of loans it can make (read: credit it can create).

When they hit this constraint, did the bankers sit around wondering what to do? Did they whistle Dixie as the loans they had already made slowly matured?

Er…no. They found a way to bend the rules. Thus came the ‘securitisation’ of mortgage loans that led to the subprime crisis of 2007. You remember, the one that collapsed the banking system around the world.

By selling on the loans to investors, the banks were able to get them off their books, meet their capital requirement and therefore make new loans. Profits, and share prices, went up accordingly.

Underneath the shiny veneer, the system was rotting at the core. One reason is that it divorced the traditional long term relationship between the lender (the bank) from the borrower. That’s why the big banks became so reckless in who they lent money to.

They no longer bore the credit risk. That distinction belonged to the suckers like pension funds who actually believed the garbage loans the banks made were ‘Triple A’.

Now let’s come back to today. According to the Basel rules, every time a bank makes a loan it has to set aside a certain amount of capital. This money can come from retained profits or money raised from investors (equity).

A profitable bank can use its retained earnings to hold more capital, which means it can lend more, which means more profit and then higher capital again.

Not only that, the amount of capital a bank holds depends on the type of loan. A bank has to set aside more capital against a business loan than it does against a property loan.

That’s because the bank can obviously seize the property if the loan goes bad. The future income stream from a business is less uncertain in terms of value. So property loans are lower ‘risk-weighted’ and far more valuable to the bank.

Be aware there is also a level of ‘self-assessment’ in this process. Banks can finesse how much capital they need to set aside according to their own risk models. Obviously, they have an incentive to choose the lower option. Are regulators surprised investor loans to real estate are booming?

But the point of today’s Daily Reckoning is to explore why higher capital ratios won’t work. The heart of it is that it doesn’t limit credit creation.

This is how the writers put it in Where Does Money Come From?:

If regulators in the future impose higher capital adequacy requirements as a counter-cyclical “macro-prudential” policy, banks will find it easier to raise more capital, as the money to purchase newly issued preferred shares, for instance, is ultimately created by the banking system, and an increasing amount is created during boom times (hence the boom in the first place).’

In other words, regulators aren’t hitting the banks where they hurt. The only real meaningful reform is to take away the banks’ power to create credit, or change the incentives to where they allocate credit in the economy.

That is to say, the property Ponzi scheme we’re slowly building down here in Australia is still running full steam ahead. Early investors will make a killing, but it’s a game of musical chairs in the end.

–If you don’t want to be the one left standing when the music stops, make sure you understand when to be in and out of the market by clicking here.


Callum Newman+,
for Markets and Money

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Originally graduating with a degree in Communications, Callum decided financial markets were far more fascinating than anything Marshall McLuhan (the ‘medium is the message’) ever came up with. Today Callum spends his day reading and researching why currencies, commodities and stocks move like they do. So far he’s discovered it’s often in a way you least expect.

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