There are two sides to the current crisis that has enveloped the financial world – a crisis of liquidity and a crisis of credit. The liquidity crisis resulted from lack of immediate access to funds to meet liabilities that were due yesterday; the credit crisis resulted from large scale defaults on low quality home loans.

There is one cardinal rule when it comes to finance – never use short term funds to fund long term assets. And businesses that have their feet on the ground understand this – the manufacturer, the retailer, the service provider (their primary assets are people, but still). Everyone in fact, except most of the banking and financial sector. Why is the rule so important (although the names are self explanatory, an explanation will do no harm)?

Short term funds – loans – need to be paid back within a short period of time (the normal classification is anything that is payable within one year is “short term” and everything else – “long term”). So you should only use it to create assets that can be liquidized on demand or within a short period of time. Long term funds, on the other hand – whether your own money or money that is borrowed – is repayable or available to you over a significantly longer time frame. So, if an investment has to go into construction of a building, or buying machinery, or doing similar stuff, care needs to be taken that you are not obliged to return the entire money whenever the lender demands it. This requires that you either embark on the project on the strength of your own equity, or on the basis of a long term loan where the lender cannot demand that you pay up the entire money at once – something that cannot be done because all your funds are locked in a long term venture. The asset classification may vary depending on the business, but the classification still exists. And when someone fails to follow the rule, they end up with a “liquidity crisis”.

Every business more-or-less understands and follows this rule – that is why they differentiate between fixed assets and current assets; equity and long term funds, and current liabilities. And that is why they have a concept of working capital – the difference between current assets and current liabilities, a difference that is generally positive and which is therefore funded either through equity or through special funding in the form of cash credit facilities from banks. Every finance professional worth his salt knows about it, and the bankers even more so (but only when it comes to their debtors) – they will have a fit if you tell them you have a negative working capital – that you are funding your fixed assets from money payable to creditors or from your cash credit facility.

The problem in such a case does not result from the quality of assets – the business is still solvent, but from a mismatch in the time taken to liquidate an asset and the time when a liability needs to be repaid. It is a kind of asset-liability mismatch – a time-based one.

Banks, however, believe that they are exempt from this rule – that they can use demand deposits and lend the money for 10-20-30-year periods. Consider how your average bank operates. They accept “deposits payable on demand” – whether in the form of balances in a current account, or savings account, or a “fixed deposit” – the interest rate offered decided by the rules that govern each account; and they lend the money to businesses and individuals for long term uses. This is a serious mismatch and a disaster waiting to happen – a consequence of the “fractional reserve system” that banks follow, and the only reason banks can get away with this is because of an implicit government guarantee in the form of support from the Central Bank. If, for example, the Federal Reserve and similar central banks across the world were to be dissolved, modern banking will be history by next weekend. But the Central Bank and so called Deposit Insurance Corporations mask the perpetual liquidity crisis by guaranteeing enough funds in case of a bank run one one hand, and if a bank fails because it has to engage in a fire sale of its assets, guaranteeing a minimum amount that would be paid to every deposit holder. If you want to compare this with something you can relate to, think about the overbooking that hotels and airlines indulge in. The only difference is they don’t go bust when the chickens come home to roost – their business model does not depend on a balancing act.

Hence, fractional reserve banking, central banks and deposit insurance corporations are “solutions in search of a problem”, and these solutions fail when the problem raises its ugly head. The answer to this is full reserve banking and stripping government of its “monetary policy” making authority. Banks have to keep at hand a sum equivalent to all demand deposits they are liable for. The only money they can lend is that which they receive specifically for such a purpose. This system will raise the cost of banking, but will eliminate the need for central institutions controlling banks. A beneficial effect of this will be the elimination of inflation – a pernicious side-effect of government control on money supply.

Credit is a much simpler concept. When a prospective borrower meets a lender, in a free market, the lender will lend only if he is reasonably sure that he will get his money back. If the borrower defaults, the lender loses his money. And interest is the reward that the lender gets in return for taking this risk. So the whole system will work as long as people keep paying up the loans that they borrowed, and the scale of operations of banks and companies help them absorb the few losses that are inevitable when lending is done on a large scale.

The problem appears when lenders don’t pay attention to the risk profile of their borrower, either because of their increased risk appetite, or because they are forced by government to grant loans so that people can buy homes. Even in this case, when multiple defaults occur in a particular category of borrowers, as long as the loans are present on the books of the original lender, it is the one who would take the hit, and in a worst case scenario, it would go bankrupt.

The Current Crisis
In the present “credit crisis”, banks and other financial institutions threw caution to the winds, put their loans in a single basket and sold the basket in pieces to other companies who piled up even more complex financial instruments on top of them and sold them to another series of buyers. A pyramid was built on a fragile foundation, and the foundation collapsed when people who were granted loans way above their repayment abilities started defaulting. The shock wave was felt throughout the system and most banks and credit rating agencies realized that they had no idea of what they were holding and how to measure its risk or value

ONE of the fastest-growing and most lucrative businesses on Wall Street in the past decade has been in derivatives — a sector that boomed after the near collapse of Long-Term Capital.

It is a stealth market that relies on trades conducted by phone between Wall Street dealer desks, away from open securities exchanges. How much changes hands or who holds what is ultimately unknown to analysts, investors and regulators.

Credit rating agencies, which banks paid to grade some of the new products, slapped high ratings on many of them, despite having only a loose familiarity with the quality of the assets behind these instruments.

Even the people running Wall Street firms didn’t really understand what they were buying and selling, says Byron Wien, a 40-year veteran of the stock market who is now the chief investment strategist of Pequot Capital, a hedge fund.

“These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models,” Mr. Wien says. “You put a lot of equations in front of them with little Greek letters on their sides, and they won’t know what they’re looking at.”

Mr. Blinder, the former Fed vice chairman, holds a doctorate in economics from M.I.T. but says he has only a “modest understanding” of complex derivatives. “I know the basic understanding of how they work,” he said, “but if you presented me with one and asked me to put a market value on it, I’d be guessing.”

Such uncertainty led some to single out derivatives for greater scrutiny and caution. Most famous, perhaps, was Warren E. Buffett, the legendary investor and chairman of Berkshire Hathaway, who in 2003 said derivatives were potential “weapons of mass destruction.”

And the market for these financial instruments vanished overnight leaving financial jargon like “mark-to-market” meaningless. As a reader of The Telegraph points out – “You can’t mark to a market that doesn’t exist.”

Most companies would have suffered losses but could still make it through if they did not suffer from a “liquidity crisis”, like AIG found out – even while being solvent – just – it had no money available to pay off creditors who demanded additional collateral. When Bear Stearns was being rescued in March 2008, this is what I said

If the subprime mortgage crisis, and the Federal Reserve coming in with a huge bailout package for affected banks was bad idea, the Bear Stearns distress sale, underwritten by the Federal Reserve is worse. Conventional wisdom, and most pink papers, favors bailouts so that the overall banking system remains unscathed by such crises. But the fact of the matter is, bailouts fix the symptoms, not the cause. The main problem hardcore capitalists and libertarians (at least I do) have with bailouts is that those responsible for the mess don’t pay a financial price. If the tax payer has to pay for the financial jugglery done by employees of investment and commercial banks, and if the only thing that prevents people from losing their trust in banks is the backing of the government in the guise of the infallible Federal Reserve with an infinite credit rating, then a private banking sector makes no sense. In that case, nationalizing all banks should be the way to go.

There is a hint of sarcasm if you read a bit further, but my position is clear, and I stand by it. The crisis is a result of persistent government interference in the market, and the market failing to understand risk. And hence shareholders, bond holders, everyone who has invested in companies that took bad decisions should pay the penalty and take a hit. If they are not willing to do that, then the answer is not a bailout but a 100 % nationalization of the entire US banking and insurance sector. If companies don’t appreciate the free market but seek handouts on every available opportunity, socialism is what they deserve. And Bush can learn valuable lessons from Indira Gandhi on this one.

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  • K. M.  On October 1, 2008 at 2:45 am

    I am interested in your ideas on fractional reserve banking. Are you saying that fractional reserve banking is inherently flawed and cannot be made to work even in the absence of a fiat currency?

  • Aristotle The Geek  On October 2, 2008 at 3:05 am

    “Are you saying that fractional reserve banking is inherently flawed and cannot be made to work even in the absence of a fiat currency?”
    Yes, because Fractional Reserve Banking is a euphemism for legally sanctioned fraud. If there were no central banks and no fiat currency, any banker who went down the Fr.R.B. road would find himself in jail. Rothbard explains it extremely well in The Case Against The Fed (pdf), but let me try my own version.

    Consider an economy where the currency used is (say) gold coins. Now if I deposit 1,000 gold coins in XYZ Bank, I am basically telling the bank to keep my money safe, and I would have to pay some charges for the use of its service – the transaction is like renting out a bank locker, the only difference being the banker knows the value of the contents of the locker and issues a receipt for that amount – this is referred to as a warehouse receipt and the banker is essentially performing the task of warehousing money and charging for the same. Historically, this was how banks began accepting public deposits (from merchants, in those days). Now if I need to pay someone 1,000 gold coins, all I have to do is hand over the receipt to that person – he now becomes the legitimate owner of the money I warehoused at XYZ Bank – if he hands over the receipt to the bank, they will give him 1,000 gold coins as long as the charges are paid. So the receipts become a de facto currency and people no longer have to carry heavy sacks of gold around.

    Things are working fine till this point. Now, XYZ Bank sees that there is nothing to differentiate one gold coin from another. It also notices that everyone does not come and demand money at the same time. So it asks, why not issue further warehouse receipts (say) of 25% of its stock of gold coins and lend the receipts on interest to traders who need money? And it does that. In our example, XYZ Bank has (say) 100,000 gold coins on deposit and it issues additional receipts to the tune of 25,000 coins. If we were to measure it using the money multiplier formula of m = 1 / R, the money multiplier (m) is 1.25 and the reserve requirement (R) is 0.8 or 80%. This is how demand deposit banking gets converted into fractional reserve banking.

    The question is would the banks be able to indulge in this activity if every customer delivered gold coins in sealed silk pouches? The answer is no. That is why fractional reserve banking cannot legally exist in a free market system.

    But there is an alternative. We have all this time been talking about “demand deposits” – money that can be withdrawn on demand. Since any non-trivial project (an umbrella term for a business plan) needs large funds over long periods of time, their only sources of funding are equity and specific long term funds (bonds being a good example). If banks want to lend to such projects, they will have to specifically secure (under contract) long term funds from clients by offering interest and hand over the money (in gold coins) to the project handlers. The warehouse receipt system won’t work here because there is no way any rational person would hand over money to a bank promising he wouldn’t touch it for (say) three months and accept a warehouse receipt in return (and also pay the holding charges). But if both parties are willing to enter into such an agreement, the receipt would have to specifically mention the fact that it is not a “demand” receipt. And this mention is sufficient for those who would accept it to demand a discount for the extended wait. This won’t be called Fr.R.B. because the time differences would be so numerous that these receipts would be treated as bonds – not as a substitute for gold coins. And even in these cases, any attempt by banks to issue receipts in excess of their stock of gold or debts on their books would necessarily have to be treated as fraud.

  • K. M.  On October 4, 2008 at 10:25 pm

    Your argument is technically right, but I am not sure if it really applies.
    Consider a bank that accepts demand deposits from its customers with the condition that it may not return the deposit if it goes bankrupt. The bank uses the deposits for investment. Such a bank would be able to offer much higher rates of interest than other banks which merely act as safekeepers. As long as the condition is explicit, the banks operations should certainly be legal. Without a central bank, reserve ratios would be much higher than what they are today but they would not be 100%.
    Such operations are distorted today because of the double authority that central banks enjoy of lending to distressed banks and printing money at will. But I think they certainly have a place.
    With their solvency at stake and no one to bail them out (except perhaps other banks), the banks would exercise much greater caution and maintain conservative reserve ratios. Of course, their dealings with individual customers would not be demand deposits, but that would be a mere technicality.

  • Aristotle The Geek  On October 4, 2008 at 11:25 pm

    The difference between my bank and your bank is the function they perform.

    My bank – the warehouse – is in the business of safekeeping and allowing me to withdraw my money “on demand”. I pay it for this service. If I wanted to invest and earn interest, I would go and place my money with an investment bank. But here, my money would theoretically not be available “on demand”. The bank might use empirical evidence and decide to keep a percentage of its reserves in cash for those who would like to withdraw it, and lend the rest in the market, but the receipts it would issue cannot be exchanged as “on demand” receipts because they carry the inherent risk of bankruptcy – something that is not the case with the warehouse bank. So if you try to buy goods in exchange for an investment bank receipt without disclosing the nature of the receipt, regardless of your contract with the investment bank, it is now you who are committing fraud on the seller of the goods.

    There is another problem. Investment banking, by its very nature is prone to the risk of loan default. So its profits depend on loaning out money at higher rates while offering lower rates to depositors, and also its default bearing capability. If it keeps idle cash on hand, the interest offered to customers will necessarily suffer. While these are technicalities, they do play a major part in shaping the business of the bank.

    Finally it all boils down to disclosure. If every one has the necessary information, there won’t be any problems. But the investment bank would still not be following Fractional Reserve Banking because the contract explicitly says you will only get your money if it is available, which is not the case with modern banking.

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