Monday 15 September 2008

Banking chaos: Umbrellas needed?

Banks are well known for lending policies where the loan is recalled at precisely the moment the client requires it. Bank lending strategy is to offer an umbrella in fine financial weather and take it back when rain starts to fall.
Lehman Brothers has filed for bankruptcy protection, Merrill Lynch has been absorbed into the Bank of America and globally banks are under pressure. Should the consumer give the banking system support in these trying times?
Whether the individual likes it or not, through the central banks and finance ministries, taxpayers’ money will be used in vast quantities to ensure the banking edifice does not collapse completely. Unlike other commercial tragedies which occur daily and receive no establishment support, banks have a special role in the generation of capitalist wealth which makes their survival essential.
In ancient times banking was fairly straightforward. Money (or Gold) was deposited, kept safely at a small charge and repaid when required. Somewhere along the way came the bright idea of lending out some of the secured money (which the bank did not own but held on deposit) temporarily to third parties for an interest fee. Experience soon showed that the bank could lend out to third parties a certain percentage of their deposits (assets) without much risk of the owners asking for it all back at any one time. This safety net percentage still underpins modern banking and is about 8% to 9%, I think.
Obviously, the smaller the bank the greater the risk involved that any large withdrawal might cause it to run out of money to pay other customers.
Although all banks have to lodge a certain sum with the central bank as security based on the size of their assets and they are legally required (like other businesses) not to trade when their liabilities exceed their assets, keeping track of the size of the assets and the liabilities has become rather complex.
Take a simplified Lehman Brothers as an example. Over the 150 years of their existence, Lehman Brothers made a lot of profit and gradually increased the size of their assets which belonged to them (own capital). Customers deposited money for Lehman Brothers to invest on their behalf which formed both an asset through the investment portfolio and a liability as money owing to clients. Because the sub-prime mortgage business was so profitable (higher risk – higher profit margin) Lehman invested in it – bought bundles of mortgages from other banks or Freddy Mac etc.
Lets say on January 2nd Lehman had a balance sheet showing 10 Billion US$ of assets and 8 Billion US$ of liabilities – a positive balance of 2 Billion US$. Unfortunately, due to the fall in house prices by July 2nd the value of the sub-prime paper assets had to be revised downwards and the balance sheet was then 7 Billion US$ assets and 8 Billion US$ of liabilities – a negative balance of 1 Billion US$. Assets fluctuate on external influences but liabilities usually remain stable or increase.
Although Lehman Brothers had substantial reserves it still meant they were technically trading illegally so they had to file for bankruptcy. The irony is that when the housing market again rises (and it will because banks etc. will give mortgages again) the paper assets will also rise in value without Lehman Brothers doing anything. It is all a question of who has the large enough umbrella.

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