Danger - Banks Ahead !

By:  Dr. Sam Vaknin

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Read "Is Our Money Safe" first!

Banks are the most unsafe institutions in the world. Every few years there is a major collapse of hundreds of them worldwide. Only lately, the US Government was forced to invest hundreds of billions of Dollars in their local equivalents of "stedilnici" - the Savings and Loans Houses. A multi-billion Dollar embezzlement scheme was discovered in the BCCI bank - and it wiped both its equity capital and the money of the depositors. Barings bank - one of the oldest in the world (330 years old) - was wiped out by an unsuccessful speculation. In 1890 it faced the very same situation - and was saved by other British banks, including the Bank of England. The list is enormous. There were more than 30 major banking crises this century alone.

That banks are very risky - can be proven by pointing to the inordinate number of regulatory institutions which supervise banks and their activities.

In the USA there are a few organizations which insure depositors against bank collapses. The FDIC (Federal Deposit Insurance Corporations) insures against the loss of every deposit of less than 100,000 USD. The HLSIC insures depositors in saving houses in a similar manner. Other regulatory agencies supervise banks, audit them, regulate them. It seems that you cannot be too cautious where banks are concerned.

The word "BANK" is derived from the old Italian word "BANCA" - bench or counter. Italian bankers used to do their businesses on benches. Nothing much changed ever since - maybe with the exception of the scenery. Banks hide their fragility and vulnerability behinds marble walls. Sometimes they hide worse things. The American President, Andrew Jackson, was so much against banks - that he even dismantled the then central bank - the Second Bank of the United States.

A series of bank scandals is sweeping through much of the developing and third worlds - Eastern and Central Europe in the forefront. "Alfa S.", "Makedonija Reklam" have become household names - and not for the better.

What is wrong with the banking systems in Central Eastern Europe (CEI) in general - and in Macedonia in particular ?

Many things - almost everything. It is mainly a crisis of trust and adverse psychology. Financial experts know that Markets work on expectations and evaluations, fears and hopes. The fuel of the financial markets is emotional - not rational.

Banks operate through credit multipliers. Supposing Depositor A deposits 100,000 USD with Bank A. The Bank puts aside about 20% of the money.

This is called a reserve and is intended to serve as an insurance policy.

The implicit assumption is that no more than 20% of the total number of depositors will come at any given moment to draw their deposits from the bank.

Indeed when such a panic happens, when ALL the depositors want their money back - the bank cannot pay them back because he has only 20% of the money in his reserves. The commercial banks hold their reserves with the Central Bank or with a third party institution, explicitly and exclusively set up for this purpose.

What does the bank do with the other 80% of Depositor A's money ($80,000)?

It lends it to Borrower B. The Borrower pays Bank A interest on the loan that he receives. The difference between the interest that Bank A pays to Depositor A on his deposit - and the interest that he charges Borrower B - is the profit of the bank.

Borrower B in the meantime deposits the money that he received from Bank A (as a loan) in his bank, Bank B. Bank B puts aside, as a reserve, 20% of this money - and lends 80% (=$64,000) to Borrower C, who promptly deposits it in Bank C.

At this stage, Depositor A's money ($100,000) has multiplied and become $244,000 (Depositor A has $100,000 in his account with Bank A, Borrower B has $80,000 in his account in Bank B, Borrower C has $64,000 in his account in Bank C). This process is called credit multiplication. The Western Credit multiplier is 9. This means that every $100,000 deposited with Bank A could, theoretically, become $900,000 : $400,000 in credits and $500,000 in deposits.

For every $900,000 in the banks' books - there are only 100,000 in physical dollars. Banks are the most heavily leveraged businesses in the world.

But this is only part of the problem. Another part is that the profit margins of banks are limited. We, as consumers of bank services do not think so - but banking profits are mostly optical illusions. We can safely say that banks are losing money throughout most of their existence.

The SPREAD is the difference between interest paid to depositors and interest collected on credits. The spread in Macedonia is 8 to 10%. This spread is supposed to cover all the bank's expenses and leave its owners with a profit.

This is a very dubious proposition. To understand why, we have to analyse the very concept of interest rates.

Virtually every major religion forbade to charge interest on credits and loans.

To charge interest was considered to be a combination of usury and blackmail.

People engaged in lending and in charging interest for their money were considered to be a form of lowlife. Shakespeare even wrote a whole play dedicated to this issue, "The Merchant of Venice".

Originally, the interest which was charged on money lent was meant to compensate for the risks associated with the provision of credit in a specific market. There were four risks :

First, there were the costs of the operation of money lending itself. Some money lenders were engaged in arbitrage and with the mere brokering of money. In other words, they had to borrow the money that they were lending on. There were costs of transportation and communications and today there are costs of business overhead.

The second risk was that of inflation. It eroded the value of the money used to repay credits. In simple terms : the Lender could buy less with the money that he got back from the Borrower - than with the money that he had lent him. In professional terms we say that the purchasing power of the money has diminished with time and the measure of this change is called inflation.

And there was a risk of scarcity. Money was a rare and valued object. Once lent it was out of the Lender's hands and all he had in return was promises. If he lent money at a given interest rate and it went up - he lost the opportunity to lend it at the new, higher rates.

The last - and most obvious risk was default : when the Borrower could not or would not pay back the credit that he has taken.

All these risks had to be offset by the (small) profit margin of the bank. No wonder that banks want to pay as little as they can to their depositors - and charge their borrowers the highest possible interest rates.

But banks face a few problems in adopting this seemingly simple business strategy.

Today interest rates are an instrument of monetary policy. As such, they are centrally dictated. They are used to control the money supply and the monetary aggregates and through them to fine tune economic activity.

Governors of Central Banks (where central banks are autonomous) and Ministers of Finance (where central banks are less autonomous) raise interest rates in order to contain economic activity which might be inflationary and exaggerated. They reduce interest rates to prevent an economic slowdown and to facilitate soft landing of a booming economy. Despite the fact that banks (and credit card companies, which are really banks) print their own money (remember the multiplier) - they do not control the money supply or the interest rates that they charge their clients.

This creates paradoxes.

The higher the interest rates - the higher the costs of financing which businesses have to pay. They, in turn, increase the prices of their products and services to reflect the new cost of money. We can say that, to some extent, higher interest rates contribute to inflation rather than prevent it.

Also, the higher the interest rates, the more money earned by the banks.

They lend this extra money to Borrowers and multiply it through the credit multiplier.

High interest rates encourage inflation from another angle altogether :

they encourage an unrealistically exchange rate between the domestic currency and foreign currencies. People would rather hold the currency which yields higher interest (=the domestic one). They buy it and sell all other currencies.

Conversions of foreign exchange into local currency are net contributors to inflation. A high exchange rate also increases the prices of imported products.

Again we find that maybe higher interest rates contribute to the very inflation that were intended to suppress.

Another interesting phenomenon :

High interest rates are supposed to insure a bank against high default rates.

In a country like Macedonia - where the morale of payments is low and default rates are high - the banks charge incredibly high interest rates to compensate for this specific risk.

But high interest rates make it difficult to repay credits to banks. A creditor will find it easier to pay his banks small interest amounts - but might find it impossible to pay much bigger interest charges.

So, high interest rates increase the risks of defaults on debts instead of reducing it.

Thus, not only are interest rates a blunt and inefficient instrument - they are also not controlled by the banks and they do not reflect the micro-economic realities.

So, what should be done ? Should interest rates be determined by each bank separately (maybe according to the composition of the specific population that he is working with) ? Should banks have the authority to print money notes (as they did throughout human history) ?

The first thing to mentally assimilate is that banks should be treated as a very risky thing indeed. If the "Makedonija Reklam" had 9 million DM in the form of its owners capital - as any Macedonian BANK does - the problem may not have been that severe. There is no reason to regulate Stedilnicas more lightly than banks. They operate as banks and they should be treated as such, capital requirements and all.

The second thing would be to educate the public : the profit margins in the banking business are so slim - that no bank can offer interest rates to depositors which are way above market rates. High returns (=profits) go with high risks.