Saturday, December 19, 2009

Banking

Modern banking is an interesting business. Banks are in the business of turning assets into money. The common misconception about banking is that banks turn deposits into loans. This is actually backwards and here is why that is.

A home builder wants to build a speculative house to sell to an unknown customer. He proposes a business plan to a commercial bank that lays out the cost to construct and sales prices of comparable homes. At this point, the house is an idea. There is no money yet, but the concept of money is there.

The bank assesses the credit risk of the borrower and the potential for loss. After doing some modeling, the bank decides that it is willing to provide financing for up to 80% of the value of the house. This leaves a margin of 20% for the price to fall in case of a default or for economic conditions. At this point, the house is still an idea and no money exists.

The home builder builds in a gross profit margin of about 18% into the cost of the house, so he basically puts no capital into the loan. Finally, the bank advances funds to begin construction. But where did it come from? Did it come from deposits? Maybe a little bit. Most likely, the bank simply created an electronic transaction that created new liquid deposits and created a debit balance on its books for the loan. The liquidity is now in the "system" with a few keystrokes.

With this credit, the home builder may now go to its suppliers who get basic materials that are purchased and manufactured using this new liquidity. On top of this manufacturers and basic materials suppliers can provide credit on the promises to pay aka receivables. This is essentially credit on credit and is technically unsecured.

So the sequence is idea --> credit --> asset monetization. The bank turned the entrepreneurial home builder's idea into newly created money. The money is added to the pile of current deposits in the system. The Federal Reserve can withdraw some of this money at any time through open market purchases of Treasury obligations (bills, notes, and bonds), which I will go over in a bit.

Ideally, if the world were all good, the Federal Reserve would withdraw any excess money that increased the per capita amount of money and credit in the system. Doing this would maintain the value of dollar holdings, i.e. price stability or no inflation. Unfortunately, what has happened is the banks have been allowed to loan unsecured money (like credit cards), which technically inflates the money supply and is backed by nothing. If these loans were backed by something like lendable equity in a home, this wouldn't be a problem. However, there is nothing, and capital requirements for credit cards are fairly low because banks use statistical methods to determine likely loss rates. In good times credit companies are able to make boat loads of money. However, in bad times, like now, credit card companies are writing off 10% of their unsecured loans. When they are backed by small amounts of capital, this causes bankruptcies and debt destruction. If you ever wondered how "wealth" can disappear, this is it. Unsecured credit blowing up. This is why stocks can fall significantly. Stock margin accounts are essentially secured by nothing but the perceived value of equity claims on corporations. If you look at the amount of outstanding margin versus the total market cap of the stock market you will see that much of the perceived value in stocks is borrowed... on the margin of the stock that is being borrowed. See ponzi scheme.

Now let's look at sovereign credit. Sovereign credit is backed implicitly by tax revenues and the productive ability of the taxpayers. While it is only implicit, I would contend that it is for the most part backed with the threat of force and improsonment on its own people. Regardless, sovereign credit is unsecured, meaning there is no collateral backing the credit.

In a country where there are legal tender laws, which is basically all of them, the government and the central bank monopolize the supply of money. If the government has a central bank, the government initially HAS to borrow from the central bank to put money in circulation. If the government does not have a central bank, then the government will mint or print whatever it proclaims as legal tender. In our case, we have fiat money, which is quite literally, money by decree and is backed only by the credit of the US taxpayer.

When the government does not deficit spend, the value of the money in circulation stays relatively constant or increases with productivity and technological advances. The government does not have to go to the central bank to put more money into circulation. Instead, it pays back its obligation through tax receipts. In this case, the central bank simply collects interest on money lent in overnight lending to underfunded banks (banks with less deposits than loan assets).

Let's look at our current situation. Today, many banks would be considered insolvent. They are only open through government and therefore taxpayer guarantees. In order to fulfill its guaranty and also its deficit financing, the government has to create money. It does this by going to the central bank, asking them to purchase some government bonds, and therefore provides the government with currency which is direct monetization. Other times, the central bank conducts open market operations in government bonds where it will buy from individuals and financial institutions. In this case, the central bank turns assets into currency, monetizing obligations of the taxpayer.

So the crucial difference is, banks monetize hard assets, while central banks monetize future tax receipts. One can be collected on in the event of default, while the other comes back with a big fat zero recovery. Every time the central bank monetizes future tax receipts, it inflates the supply of money and credit. This in turn leads to the common idea of price or purchasing power inflation over time due to the supply of money and credit increasing.

The central bank sees the contraction of private credit with great unease because without private credit, public credit has to expand to maintain asset prices. But the pace of private credit contraction is continuing due to the taxpayers' distrust of bankers. My guess is that this is a secular shift towards less debt in people's lives. My premise during the entire crisis has been that instead of the central bank accepting private credit contraction, it will monetize taxpayer backed credit to match any private credit contraction. This will support asset prices, but will not create significant private sector jobs because the government will have to spend the money, and it does so in a rather inefficient way because the process is politicized.

Much of this crisis would not have been created or lengthened if we had no central bank or if the government did not have control over money. Money, chosen by the free market, can be anything and the most common forms are gold and silver for simple reasons; they are difficult to counterfeit and are divisible. Gold and silver can be used as collateral for credit. In fact, banks used to be run as storage facilities and clearing houses for gold credit. Banks would issue depository receipts against which individuals and businesses would transact. It's a very simple system and it could be replicated very easily electronically.

Ron Paul has some great ideas on controlling fiat money's expansion. The first idea is to end legal tender laws that basically force people to transact in Federal Reserve notes. If there were no legal tender laws, the market would decide with what type of money to transact its business. My guess is that companies would settle transactions in gold and silver because they would not have to maintain a huge treasury department to transact in money markets, treasury bills, and other short term funding mechanisms because all of the gold and silver could be kept in bank vaults for a relatively small fee. If the first idea wouldn't pass congressional approval, another idea is to allow gold and silver to be used as legal tender in payment of taxes. Very similar concept to the first idea.

If you really start to delve into the financial system, it is relatively easy to see that it was designed by investment bankers looking to scrape a fee off of everything. Limits on FDIC insurance force medium and large businesses to create a treasury function that transact in money and treasury markets where banks get a fee. The monopoly on money by governments allows international investment banks to collect a foreign exchange fee, whereas gold and silver settlement between corporations would be a very straightforward transaction. 401(k)s are fee generating machines for the mutual fund racket. Tax deductibility of interest on housing encourages people to go into housing debt and raises the price of housing. Credit card servicers like VISA and Mastercard take a 3% fee right off the top of any card transaction. War is an extremely profitable venture for banks because usually the government has to borrow money to pay for it. It issues treasuries which it then sells to dealers (at a discount) who then distribute them to their clients (for a fee). What's not to love if you're a banker? Bankers are extremely creative in finding ways to scrape off the top of every transaction. Cap and Trade is the next new banker revenue source and eventually they will come up with bigger and better sources to suck free capital through their vacuum.

Overall, I would say that most bankers are decent people. They just want to make money like the rest of us and they don't really see from a global view what they are doing. In fact, if you go to a commercial bank, I would venture a guess that 99% of the people that work there have no idea how a bank really works. The evil people are those that legislate fees into your life and force you to pay banking fees. This is corporatism at its worst and the focus of my ire is toward these people who turn an entity that was initially supposed to protect liberty into an entity that forces people into bank and debt slavery. Welcome to the United Banks of America. That'll be a 1% fee.

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