Tuesday, 16 September 2008

Collapsing banks, what's the problem?

So another bank has gone to the great counting house in the sky, this time Lehman Brothers. The thrusting young men in red braces will draw fat bonuses no more. Does it matter?

The starting point must be to investigate why this bank went under. That is fairly simple, it had obligations to pay money but no money with which to pay them. Although it is dressed up as a mysterious business comprehensible only to the brilliant, investment banking is pretty straight forward. Customers hand over a lump of cash and and the bank invests it hither and yon in the hope that a profit will ensue. The customer receives some of the profit and the bank receives its cut. Everyone is happy and the world continues to turn. Of course they won't attract many customers by saying "hand over cash and we'll try to make it grow", so they offer incentives such as a minimum rate of return over a given period. The customer must leave his money with them for a minimum time. At the end of that period the banks must not only make sufficient profit to be able to pay the customer his guaranteed interest they also have to repay the capital sum if the customer demands it. Some do and others decide to leave it in place for another year or two.

When times are good there are always new investors so those who withdraw their lump sum can be repaid from the lump sums brought in from new business. This encourages the investment banks to take out some very long term investments with the money they manage. Having secured funds from customers who invest for one or two years, they lend that money to others over ten or fifteen years. Because there are always new customers to replace those who withdraw, it is safe for them to "borrow short and lend long". The problem comes when the economy takes a downturn. Instead of, say, one customer in every three withdrawing their money at the end of a one year deal, two in three demand repayment because they need it for other things, and replacement business does not come along to fill the void because potential customers are wary to tie-up funds when they know they might need them. Unless the bank can get its hands on cash it has nothing with which to repay its customers. Of course they do not only lend long they also take out short-term investments which can be cashed-in to provide money at relatively short notice, they hold some money in low interest rate accounts allowing very quick withdrawal and they can borrow from other banks; the key to remaining alive is to have sufficient ability to repay your customers when they demand it.

An investment bank which does not balance its investments correctly can be caught out by being unable to repay its customers. That is what happened to Northern Rock and it is what happened to Lehman Brothers. Too much long lending and an inability to borrow from other banks made them unable to repay their customers. Once there is a hint of this happening, other banks will not only be reluctant to lend to get them out of the hole but they will call-in outstanding loans if they can in order to protect their own businesses. Inevitably when people hear that a bank is in trouble they want to get their money out as quickly as possible and that is so for other banks just as it is for individuals. Those tied into fixed term deals cannot do so unless there is a get-out clause, which there often is at a price of so-many months interest and panicking customers are happy to pay £500 in lost interest where the alternative is losing far more.

In theory there should not be a problem because the funds deposited by customers have been invested and those investments can be used as collateral for a loan from another bank. But, as we saw with Northern Rock, unless the long-term investments are sound they do not provide sufficiently strong collateral for another bank to be prepared to lend. This is why there was so much discussion about the "quality" of Northern Rock's investments. They had lent far too much to people who could not afford to repay them and the houses and flats against which mortgage loans were secured were starting to lose value. Negative equity for the householder is also negative equity for the bank holding a mortgage over the property. A combination of too many weak long-term investments, a general tightening of credit (so that other banks would only lend against very strong security) and a demand by customers for repayment results in the available cash running out and the business going under.

That is all pretty basic stuff, what is more difficult is the effect the collapse of one bank might have on the whole banking sector. It is inevitable that other banks will be affected because some customers will apply a no smoke without fire analysis and keep their cash under the bed instead, but that will not cause any real problems unless a vast number do it. What can cause a real problem is continuing unwillingness for banks to lend to each other. Banking is a very fluid business, the most enormous sums go in and out of banks every day. At the end of the trading day a bank which has received a lot will want to get a return on that money before it is placed in longer term investments so they lend it to other banks who need a bit more to meet liabilities before they, in turn, have a day giving them an overnight surplus. All banks are affected by this so they lend to each other, sometimes many millions of pounds for a very short time, but it needs to be done to ensure surplus funds provide a return and a shortfall can be financed by borrowing. A general lack of confidence between banks can upset this process with the result that all banks become excessively cautious and businesses find it difficult to borrow to fund progress. Almost overnight we can find commercial credit becoming scarce and major projects being delayed or cancelled because there is no way of funding them.

Is that a reason to bail out a bank like Northern Rock or Lehman Brothers? I cannot see why it should be. After all the problem with Northern Rock did not go away when it was nationalised, it still had a rotten investment portfolio and Lehman Brothers would not suddenly become a sound business simply on receipt of taxpayer subsidies. The problems leading to collapse are too deep seated to be solved quickly by a one-off injection of cash from the treasury; structural change is required, which takes time and, as we are seeing with Northern Rock, time used in that process is very expensive time indeed.

Banks must be treated like any other business. If they are run well they will make a profit, if they are run badly they will fold. Far better to let all banks know that their fate is in their own hands, only in that way will they have a proper incentive to lend wisely. After all, banking collapses are almost always caused by bad lending decisions.

1 comment:

Bobsheadrevisited said...

Thanks, Fatbigot. I now have a much clearer idea of something that seemed a 'mysterious business' to me!