Banking Regulations

As I see it........ by L. Berney

The collapse of the World’s financial system is blamed on the excessive and irresponsible loans made by the banks. The rules under which banks operate have been proved to be disastrously inadequate. It seems to be universally agreed that when we get out of the financial mess we are in, the rules governing banking operations will have to be re-written.

WHAT BANKS DO

Banks perform three main functions:

• A checking or current account function A safe-keeping service for customers’ money and the handling of payments and receipts
• An interest-bearing deposit function Customers place money “on deposit” with a bank with a specified date for that money to be returned and a specified arrangement for the payment of interest
• A loan function Granting loans to individuals and businesses, and charging them interest for doing so. As with deposits, the details for the return of the loan and the interest to be paid are specified in advance
  

IN 2008, THE WORLD’S FINANCIAL SYSTEM WENT HORRIBLY WRONG!

In 2008, the world’s financial system collapsed – we now have a world-wide recession. Blame is leveled on the world’s banks because, over the last two or three decades, they lent out too much money too easily.

After the “Wall Street Crash” of 1929 and the “Great Depression” of the 1930s (caused, as now, by excessive bank lending) new banking rules were established which geared the maximum amount banks could lend to the amount of money deposited with them -- the “Cash Reserve Ratio” of the “Fractional Reserve Banking” system. Starting in the 1980s, governments began to relax those rules, to allow the banks to reduce their Cash Reserve Ratios, to lend more. The thinking at the time was that restricting the amount of money loaned was stifling economic growth. By around the year 2000, most banks were “de-regulated” and were free to loan out as much money as they wished – it was left to “the efficiency of the free market” and for the banks themselves to decide how much.

The amounts they loaned escalated. The amount banks that lent out compared to the deposits they held was, on average, as follows:

UK in 1968 loans were 5 times deposits – 1988 20 times – 2008 over 30 times

USA in 1968 loans were 8 times deposits – 1988 12 times – 2008 over 30 times

Germany in 1968 loans were 5 times deposits – 1988 6 times – 2008 over 30 times

This heavily increased lending (and therefore spending) and gave rise to higher than realistic living standards – a BOOM – but a boom based on excessive debt. Due to various reasons – such as fierce competition between banks; lowering of credit criteria (125% mortgages!); belief that property would keep going up; lax management practices; variable mortgage rates, the greed of bonus-earning executives -- loans were made to people and businesses who, in the event of a downturn, had little or no possibility of paying the interest due on their loans.

In the USA in 2007/8, mortgage interest payment defaults started to occur which rapidly led to a fall in property values. Banks stopping further lending, there was a “credit crunch”, and that in turn led to a world-wide economic downturn. The debt bubble has burst and we now have a BUST.

NEW BANKING RULES – A PROPOSAL

Since the BUST was caused by the banks over-lending, how should the rules under which banks operate be written so that this BOOM-BUST situation does not to happen again? As a Bank of England report says, “...a fundamental re-think of safeguards against systemic risk is needed.” The G20 summit and indeed the whole world now see that the old banking rules are woefully inadequate and that the need to devise a new set of banking rules is essential.

In an ideal world, the economy would be based on, “Live within your means -- you can only have what you can pay for – if you can’t pay for it, you can’t have it”.

However, it is a fact that the economy of our world relies on many people and most businesses being in debt -- having what they can’t pay for.

If loans were prohibited I expect we would all be back to the Stone Age!

I am not a banker but, for what it is worth, I will throw my hat into the regulation ring!

My proposal for new banking rules (bank regulations) would be as follows:

SEPARATION OF BANKING FUNCTIONS

The first requirement is the separation of current banking functions. The functions currently performed by banks would be re-structured. “Banks” would perform current/checking account functions only. Deposit and loan functions would be separated off from our existing banks and would be performed by legally separate commercial entities, “Finance Houses”.

BANKS

Banks would supply current/checking account services only.

• Safe-keeping service for customers’ money
• Money deposited immediately re-payable on demand (cash or bank cheque)
• Payments to any other bank (debit cards, cheques, bank-to bank transfers, standing orders, etc)
• Receive cash or transfers from other banks
  

Banks would have on hand at all times the total of the deposits lodged with them, a banking system known as “100% Reserve Banking”.

Banks would not “use” customers’ money in any way, would not make loans of any kind, would not permit overdrafts, would operate debit cards but not credit cards, would neither pay interest nor charge interest. Their income would derive solely from bank charges.

Each Bank would have an account with the country’s Central Bank. At the close of business each day, Banks would transfer any amount in excess of 20% of the total of the amounts deposited with them to their account at the Central Bank, or call back from their account any amount below 20%. This would ensure that, in the event of a Bank failure, 80% of the Bank’s customers’ money was securely held in the Central Bank and could be promptly returned to them.

A state-operated Compensation Fund funded by compulsory contributions from all licensed Banks would, in the event of a Bank failure, make good the difference between the 80% funds held by the Central Bank and failed bank’s customer account balances.

FINANCE HOUSES

Finance Houses would operate the deposit-and-loan and mortgage function currently operated by banks.

• Finance Houses would be licensed to operate “time deposits accounts” as banks do now, i.e. the guaranteed return of a deposit by a specific date and the guaranteed payment of specified interest amounts
• Finance Houses would be licensed to provide loans to individuals and businesses, and to charge interest. They would be prohibited from investing in the financial markets (such as derivatives, securitised mortgages, hedge funds, etc). They would be authorised to issue credit cards
• For each Finance House, the maximum permitted total of loans would be geared to the total of their customers’ deposits. The maximum “loan-to-deposit ratio” would be limited to 5 times. That is, the total amount loaned out must not exceed 5 times the total amount deposited -- a “Fractional Reserve of 20%”
• Where a loan is secured by property (a mortgage), or an asset (a car etc) or securities (equity, shares etc), the amount of the loan would be limited to a maximum of 80% of a realistic current selling value of the property, asset or security -- a “loan-to-value” of 80%
• The amount of the interest payments on loans/mortgages would be “fixed” not variable, i.e. could not be increased during the lifetime of the loan
  

To curb Finance Houses from making imprudent and/or excessive loans, the following rules would be applied:

• Pre-Loan Vetting. In setting up the loan and interest arrangement, the Finance House making the loan (both secured and unsecured, including credit cards) would be obligated to investigate in depth the current financial and other circumstances of the borrower to ensure that the repayment/interest terms are not unreasonable and are likely to be met. Official detailed “loan vetting guidelines” would be laid down with which the terms of loans had to comply. For vetting purposes the income amount would be actual, would exclude anticipated income
• Loan Defaults and Recovery. Should the borrower default on the interest or repayment terms of the loan, the lender (the Finance House) would, as now, have right of redress through the courts. The lender would produce to the court the result of the vetting investigations it made prior to the loan. The court would find for the lender only if at the time of the loan the “not unreasonable”, the “loan vetting guidelines”, and for secured loans, the “loan-to-value” requirements had been met.
  

A state-operated Compensation Fund funded by compulsory contributions from all Finance Houses would, in the event of a Finance House failure, pay depositors up to the first £50,000 of their deposits.

LIKELY OUTCOME

If these banking rules were to be adopted, and when the World economy had steadied, what would be the likely outcome?

I anticipate that the overall standards of living and prosperity would not for several years return to the standards of 2007/8, which, as we now know were unsustainable. I anticipate that the economy would gradually return to the levels of the 1970s.

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Other Financial papers in this series:

Recession I, Recession II, Recession III, Money Supply, Prices Wages & Inflation.

RECESSION Part IV

image credit: www.adweek.com

As I See It.......... by L. Berney

MONEY SUPPLY

"The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple that the mind is repelled.”

- John Kenneth Galbraith, Economist, in his book “Money: whence it came, where it went”

Sources of the World’s Money Supply

The money of every currency, Dollars, Pounds, Euros, etc, originates from two sources: Government Money and Commercial Bank money.

• Government Money is the money in circulation that has been issued by that currency’s Central Bank. It consists of coins, banknotes, bills and bonds issued by the Central Bank. This is “real” money.
  

• Commercial Bank Money is created by Commercial Banks when they issue loans (mortgages, business and household loans). When a bank makes a loan, it creates additional money, “out of thin air”. This is “debt/money”. When a Commercial Bank makes a loan – issues debt/money – the total amount of money in circulation is increased. When the loan is paid back, the total amount of money in circulation is reduced.
  

• Of the total amount of money in circulation globally, the amount of Commercial Bank generated money far exceeds Government money

Excessive Debt/Loan Money and the Credit Crunch

In the history of banking, banks originally lent out only a small proportion of the money that their customers had deposited with them. Gradually, over time, banks lent out more and more of those deposits. Eventually the total amount of debt/money they lent out became more than the amounts that were actually deposited with them. After the banks were “de-regulated” in the 1990s, the amount of debt/money commercial banks were lending out came to bear no relation at all to the amount on money deposited with them. By the time of the credit crunch (2007/8), Commercial Banks world-wide had got into the habit of lending out debt/money amounting to thirty, forty and even as much as fifty times the amount of the money that was deposited with them! At that point, inevitably, the debt bubble burst.

In 2007, the whole of the world’s economic system – the “free market”, capitalism, the living standards we all, both rich and poor, had got used to – depended entirely on the existence of the huge and ever growing amounts of debt-generated money in circulation. When in 2008 the debt bubble burst, the banks suddenly stopped lending. However, outstanding debts were and still are being paid back to the lending banks – the result is that the total money in circulation is being reduced rapidly.

With less money in circulation the world’s economies are slowing down, businesses and factories are closing, people are being sacked and homes are being re-possessed. People everywhere are holding on to what money they have and are spending only on essentials. Everyone’s standard of living is going down. We have a recession, if not a depression.

Mr. Micawber, in Charles Dickens' David Copperfield, summed it up:

Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

With the recession worsening, the world expects governments and politicians to “do something about it”.

What people mean by “doing something about it” is for governments to do whatever it takes to get back to the high living and employment standards of 2007. Clearly, that can only happen if the total money supply and economic activity round the world is returned to what it was in 2007. But we all now know that the level of debt incurred in the 2007 level of money supply is unsustainable.

The Politicians’ Solution

Since the banking crisis of 2008, the commercial banks have learned a lesson; they have returned to the prudent lending practices of 50 years ago (we don’t want to make the same mistake twice!). Moreover, much tighter government “regulation” (i.e. a brake on bank lending, and thus further reducing the money supply) is the political order of the day.

So, what is the solution? Governments and politicians round the world are floundering around to find an answer. The answer they say is, “to get the banks lending again” In the main, two solutions are being pursued: Quantitative Easing and Fiscal Stimulus.

Quantitative Easing

What is “Quantitative Easing?” In brief, it means increasing the amount of Government Money (“real” money) in circulation. As the amount of Commercial Bank debt/loan money shrinks world-wide, the idea is to replace it with Government Money so as to keep the total amount of money in circulation at the level it was before.

The way Governments do this is to have their Central Banks buy up assets - usually government and corporate bonds. How? The Central Banks simply create money out of thin air – just like the Commercial banks did before! The institutions selling those assets to the Central Bank (Commercial Banks, Insurance Companies, etc) will then have "new" money in their accounts, which theoretically should boost the overall money supply so that the Commercial Banks can, “start lending again”.

Fiscal Stimulus

A Fiscal Stimulus is triggered by cutting taxes and/or increasing government spending on infrastructure improvement, major public works and the like. It is so called because this increases the total amount of money in circulation and therefore (hopefully) stimulates a country’s level of economic activity, at least in the short run.

My conclusion

Will the measures being taken work? Will they, as the public demands, get employment and living standards back to the levels of 2007 again, and then go on getting better every year?

No prizes for the answer. You don’t have to be an Einstein to see through the contradiction and the fallacy in the “solutions”.

My opinion is supported by Henry Kissinger, former US Government Minister of State, who summed it up nicely yesterday in a BBC News clip:

What they (the politicians) are doing is substituting a public debt crisis for a private debt crisis...

As I see it, over the last 25 years or so, due to the commercial banks issuing ever more debt/money (phoney money?), the whole world has been living well beyond its means – there has been a BOOM. Now that the inevitable has happened, and as the excess volume of debt/loan money works its way out of the economy down to a sustainable pre-1970 level again, as it must, the world economy is going to experience one-hell-of-a BUST!

Postscript

An example of “loan-culture” thinking:

Since commercial banks are economising and closing down unprofitable branches, it was recently suggested that the 6,000 UK post offices should offer a banking service. One of the criticisms was that this would not be of any use since, “...post office banks, being new, would not have any money to lend out”!!!

RECESSION Part III

image: pophangover.com

As I see it......... by L. Berney

THE UK ECONOMY - FEBRUARY 2009

FACTS AND FIGURES:

PERSONAL DEBT

• Average debt per household (including mortgages) -- £59,702
• Average debt owing by each adult person (including mortgages) -- £30,500

• Total debts, 2008 (personal and mortgages) -- £1,457 Billions

(a Billion is one thousand million -- 1,000,000,000)

Of which:

• Total personal debts --  £233 Billions
• Total mortgages -- £1,224 Billions

• Total debts 5 years ago -- £1,100 Billions
• Total debts 10 years ago -- £550 Billions
• Total debts 15 years ago -- £400 Billions

• Number of properties with mortgages -- 11.7 Millions
• Average mortgage amount per property -- £104,000

In 2008 the Citizens Advice Bureaus dealt with -- 4,760 debt problems a day

CREDIT CARDS

• Number of credit cards in circulation -- 71 Millions
• Value of transactions in 2008 -- £124 Billions

BANKRUPTCY

• Persons or firms declared bankrupt in 2008 – 300 a day -- over 100,000 in the year
• Estimated for 2009 -- 400 a day – another 140,000 in the year

HOUSING

• Property being bank re-possessed in 2008 -- 125 a day
• Estimated for 2009 -- 200 a day

• Average decrease in house prices in 2008 -- £102 a day

• Average house price in February 2008 -- £147,000
• A year ago --  £219,000 -- down 33%

CARS

• Estimate of new cars to be registered in 2009 -- 1,720,000
• Actual for 2007 -- 2,400,000 -- down 28% in 2 years

EMPLOYMENT

The total population of the UK is 61 Millions

Of the 61 Millions total:

• In work -- 29.4 Millions
• Unemployed seeking work -- 2.0 Millions
• Of working age but not seeking work -- 7.9 Millions
• Retired, and under 16s -- 21.7 Millions

• Unemployment is now at -- 6.3% or 1 in 17 of the workforce
• Unemployed total is currently increasing by -- 1,500 a day
• Unemployed estimate total end-2009 -- 3,000,000 – that is 1 in 10 of the workforce

FINANCIAL

• A year ago, £1 was worth €1.40 – today €1.10 – a fall of 21%
• A year ago, £1 was worth $2.05 – today $1.42 – a fall of 31%

• A year ago the FT100 Share Index stood at 5980 – today 3850 – a fall of 36%

• Income for savers. A year ago, the Bank of England interest rate was 5% -- now 1%

• In 2001, money deposited in banks approximately equaled money loaned out by banks
• In 2008, money loaned out was £700 Billions more than the money deposited

UK NATIONAL IMPORTS AND EXPORTS

• In 2008, UK imports cost £46,097 Millions more than receipts from exports
• 5 years ago, UK imports cost £25,995 Millions more than receipts from exports
• 10 years ago, UK imports cost £6 801 Millions more than receipts from exports
• 11 years ago, UK imports cost less than receipts from exports

WHEN WILL THE RECESSION END?

WHEN WILL THINGS RETURN TO WHAT THEY WERE IN 2007?

As at February 2009, there is no evidence of the recession ending. On the contrary, the recession is deepening. Housing prices are still falling, bank re-possessions are increasing, unemployment is increasing, car sales are falling, bankruptcies are increasing, the value of the pound is going down, and the import/export trade gap is widening. In general, most people, rich and poor, are spending as little as possible and buying only necessities.

It has to be realized that the economy and the level of personal expenditure prevalent in 2007 was based on, indeed relied on, a very high level of business and personal debt. Events of the last 12 months have shown that debt level to be unsustainable – in 2008 the debt bubble burst. 

As the living standards of 2007 were achieved only through an unsustainable debt level, it is clear that the future economy and standard of living of the UK will inevitably have to be reduced to a lower and sustainable level.

For the debt burden to be kept within sustainable limits, the country must return to the prudent practices and regulations of the past. In my view, the following regulatory principles will have to be implemented.

• Housing.    Mortgages will have to be limited to not more than 80% of a conservative valuation of the property, and the lender will have to ensure that the payment terms are within the purchasers means. This will probably result in an increase in rented property and a reduction in house-ownership.

• Cars and large household items. “No deposit” offers will have to be illegal and the seller will be responsible to ensure that the payment conditions are within the purchaser’s means. Personal loans by banks will have to be severely restricted.

• Consumer spending, smaller items. The concept of Credit Cards will have to be discontinued –Debit Cards only. Retailers will still be able to extend credit to their customers but only at their own risk.

• Business loans. Regulations will have to be in force to restrict bank loans to businesses for essentials only; to eliminate purely speculative bank lending. Businesses seeking speculation funds will have to attract private, not bank funds. Alternatively, they will have to raise funds by sharing their equity.

To the question – “When will the recession end?” – the answer is (as I see it) that the recession will continue until the excess debt has been worked out of the economy and the amount of the nations debt has been reduced to a sustainable level. That, in my opinion, will not be in 2009 or in 2010. It might be in 2011, more likely to be in 2012.

To the question -- “When will things return to what they were in 2007?” – the answer is (as I see it) -- “They won’t – at least, not in the foreseeable future”.

The recession of 2008 - as I see it, part 2

by L. Berney

It is generally accepted that the amount of debt in the world has been increasing steadily over the last two decades and that by 2007/8 the ‘debt bubble’ had become so inflated that finally the bubble burst.

But where does debt come from?

Debt originates from banks throughout the world lending money – lending to individuals, businesses and to institutions. The principle of banks lending money is centuries old; bank loans are an integral part of our global economic system.

The basic principle of banking is, or was, this. Individuals, businesses and institutions deposit their cash with an authorised bank. The bank retains a small proportion of that money in ‘liquid’ cash to ensure that it can make withdrawals to individual depositors on demand. It then lends out the balance of the deposits to other individuals, businesses and institutions. Banks pay interest to their depositors and charge a larger interest to their borrowers.

Until recently, banks were ‘regulated’ by their country’s governments to ensure that they did not lend out more money than the total of the money deposited with them. That is how it was, but some 20 years ago governments world-wide relaxed their banking regulations and banking was gradually ‘de-regulated’. This meant that banks were no longer restricted from lending more than the amount of their deposits – they could use their own discretion as to the amount of the loans they could issue. By 2007/8 it had got to the stage that banks were lending out very much more than the money deposited with them, in some cases ten times more.

If banks facilitate loans within sustainable limits, the result is beneficial; the economy grows and standards of living improve. If banks issue loans excessively, the inevitable result is financial and social disaster. Globally, banks have been lending vast amounts in excess of the deposits they held – that vast amount is the ‘debt bubble’.

How is it possible for a bank to lend out more money than the money deposited with it? Like this. When a bank lends money to, for example, an individual in order to purchase a property, or to a business to enable it to expand, that bank ‘transfers’ funds to another bank. But in practice NOTHING TANGIBLE CHANGES HANDS – not gold, not even bank notes. A bank-to-bank transfer requires nothing more than for the two banks to post entries in their respective books. A transfer, having come from another bank, is accepted by the receiving bank and the borrower’s account at the receiving bank is duly credited. That’s it!

What about the banks’ balance sheets? Every company, including a bank, must remain ‘solvent’ – its liabilities must not exceed its assets. With a bank, ‘liabilities’ consist of the amounts deposited with it. Re ‘assets’, believe it or not, when a bank pays out a loan, the full amount of that loan counts as an asset. So, a bank’s assets include all the money owing to it in the form of loans. In this way, from an accounting aspect, since loans are counted as assets, however much it lends out, it remains legally solvent.

In order to make as much profit as possible, and in the belief that property values would go on climbing, and that businesses to whom the banks lent money would go on being profitable, banks have been increasing their amounts loaned out to the maximum they could achieve. The greater the amounts they loaned (and the interest they charged on those loans) the greater their profits. In the banking world, a culture of greed developed. Pressure on management to generate ever greater profits, general lowering of credit criteria leading to the issuing of ‘sub-prime’ i.e. risky loans, an explosion of credit cards, granting of mortgages for the full amount of, and even more than, the purchase price of a property, sloppy management practices – all of these became normal. This culture of greed was fueled by the bonus system which paid large bonuses to bank executives, based solely on the profit they generated.

Thus, after de-regulation, using Alice in Wonderland accounting, the amount banks world-wide loaned out increased dramatically – the amounts of the loans were no longer related to the amounts on deposit.

It is the amounts, far in excess of the amounts deposited, that banks have loaned that has resulted in a global unsupportable debt bubble.

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What went wrong?

This ever-increasing-debt economy worked well until sometime in 2007/8 when, starting first in the USA but now world-wide, some of the ‘sub-prime’ borrowers were not able to pay their mortgage payments when due. Some properties were ‘bank re-possessed’ which caused property prices to fall. As a result, some banks were forced to ‘write off’ a part of their loans/assets. Then, to maintain solvency, they were obliged to borrow cash from other banks. Soon, those other banks became unwilling to lend, or if they did so, only at a very high interest rates. We now had a ‘credit crunch’. In a very short space of time, bank loans and the credit on which our economy depends dried up. Factories started to close. Unemployment rose. The public had less disposable cash to spend. Due to the ‘knock-on’ effect on the global economy, the pace of the richest and the poorest countries alike started to slow down.

In the Autumn of 2008, the size of the global debt became unsustainable – the debt bubble had burst -- we now have a ‘recession’.

A global recession inevitably means the lowering of global living standards. Politicians world-wide are attempting to mitigate the effects of this recession by various means, but the ‘laws of economics’ are immutable. The global economic recession will continue until the excess credit has been worked out of the world’s financial system and the volume of debt has been reduced to a sustainable level, to the level it was, say, 30 years ago.

G-20 Financial Crisis Meeting - as I see it

(photo from www.worldbank.org/za)

“G-20 leaders meet at a summit in Washington, D.C. to discuss the current financial crisis.”

How did the 20 leaders get to be the leaders of their respective countries? They got there because they had the sharpest elbows in their own Political Parties and fought their way up to be the “Leader of the Party”. Their party got elected to government and so they became the “Leader of the Country”.

Granted they are expert at “How to get yourself to the top in Politics” but few, if any, are experts in economics, or have the background knowledge to know what to do in a very complicated and dangerous financial crisis.

Yet these are the people who are making crucial financial decisions that will affect us all!

Gawd help us!!

L. Berney

The recession of 2008 - as I see it

(image from http://www.contractorselling.com)

by L. Berney

It is generally recognised that the world is in financial recession, and is in danger of falling into a depression. Zillions of words have been written about the current situation, what caused it, what should be done about it, and how to prevent it from happening again. But none of the articles I have read sets out the problem the way I see it.

The present standard of living of everyone in the world, at whatever level -- high, average or low -- is related to, and depends on, the amount of debt around the world. If the debt per head of the population was at the level it was say 30 years ago, everyone's standard of living would be lower. Over the last 30 years or so, that debt 'bubble' has grown steadily and substantially. This current financial crisis is, it seems to me, due to that debt bubble having grown unsustainably large until, inevitably, it had to burst. (We all knew it had to happen, didn't we!)

Everyone (with hindsight) blames the banks and financial institutions for handing out too much credit too easily – ‘unbridled capitalism’. Individuals have been obtaining a virtually unlimited number of credit cards and therefore virtually unlimited credit. Mortgages have been handed out, not only with no deposit, but for amounts greater than the value of the property, and to persons whose income was clearly insufficient to cover the mortgage payments. Likewise imprudent loans have been available for cars, furniture, etc. Bank loans have been handed out to individuals and commercial firms based on inadequate credit limits.

Starting in 2007 with some USA ‘sub-prime’ borrowers unable to pay their debts, the banks etc. found themselves running out of funds and in trouble. Problems snowballed and the debt bubble burst. As a result, interest rates on loans have doubled and trebled and new loans are hard if not impossible to arrange. The whole of the world’s economy, based as it is on a continuing and unsustainable level of debt, is collapsing.

Now, the world is screaming out for our economy and standard of living to be maintained at the level it was last year. For that to be, the world will need to run with the same high level, indeed the unsustainable level of debt as there was before! Seems to me, very obviously, that you can't have an inflated standard of living funded by an unsustainable level of debt, and a prudent limited credit policy at the same time!

Nevertheless, the world’s leaders and finance ministers are trying to do just that. Their ‘solution’ seems to be to capitalize the banks from public funds and thus to shift the risk from the private sector to the public sector. This is not a long-term solution – this will only postpone the inevitable.

Recently, the CEO of a major bank said, “We were making loans too easily. Earlier this year it became necessary to write down heavily the value of our securities. To remain solvent, we were obliged to accept loans from our central bank, at a high interest rate – as a result, the value of our shareholders’ shares has fallen by two thirds. We have amended our loan criteria and we are now making far fewer loans than previously. The government is urging us to resume lending at the same level as in 2007. If we were to do that, the result would be the same as it was in the period we have just come through – massive write-downs and further heavy losses. We do not want to make the same mistake twice; consequently we have decided to continue with our reduced lending policy. This bank is a commercial business, not a public benefactor. The bank belongs to its shareholders -- our aim is to make profits. We are under no obligation to make loans that we consider unsafe. We will not be complying with the government’s requests.”

As I see it, the global debt level will of necessity, and by the laws of economics, fall to a lower level, the level it was in, say, the 1970s; this inevitably means that the people’s standard of living throughout the world will fall accordingly. The imbalances in the national and international financial systems are such that unwinding them will require a prolonged and painful global recession. Global debt reduction, leading to recession, leading to lowered living standards, will take its course.

In economics, there is no such thing as a free lunch!

What of the future? To maintain our Western-style free-market economy, while avoiding the building up of excessive debt followed by an inevitable recession, there has to be Financial Regulation. Getting the amount of regulation right is difficult – there has to be not too much and not too little. It is now widely recognised that the policy of financial de-regulation as practiced in recent years has to be reversed, or at least, tightened up. Over the coming months we shall see what the world’s leaders come up with.

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Footnote 1
Economists have been producing ‘models’ of how to manage the economy for centuries. Apparently, they are now “learning the lessons” of 2007/8. It is amazing that, in the 21st millennium, economists still cannot agree on how the world’s economy should be managed!

Footnote 2
Islamic law has some rules about lending and borrowing: you can only have what you can pay for; charging (and paying) interest on loans is forbidden; making money by lending money is forbidden. (Maybe, in the light of the boom and bust mess our free market system regularly gets us into, that’s not such a bad idea?)

Banks not lending to each other

by L. Berney

From what I understand from the media, the cause of the worldwide economic slow-down, the recession, is because the banks have severely reduced the mortgages they are issuing, and the loans they are prepared to make to individuals, commercial firms and institutions. Moreover, any such mortgages and loans are at much increased interest rates.

The reason for the banks' sudden reluctance to lend is said to be because. “the banks are no longer willing to lend to each other”.

I always understood the banks’ operation to be this. Individuals, firms and institutions deposited money with their banks. The banks then lent most of that money to other individuals, firms and institutions. Banks “lending to each other” played little or no part of the process.

(I am aware that a small minority of banks, e.g. Northern Rock, augmented their deposit income by borrowing from other banks, but I thought that this was very much the exception, not the rule.)

Can anyone explain to me where my understanding is wrong? Is it true that the reason banks are not making loans is because they are not lending to each other -- and if so, why?