Monday, October 5. 2009

Posted by Karl Denninger in Banking System at 12:56
(Page 1 of 281, totaling 1401 entries) » next page

Sound Banking: A Capitalist Imperative

It is time to "clear the decks" and talk about exactly what a sound banking system is - and is not.

It is time to identify that which is an exercise in capitalism, and that which is an exercise in fraud.

It is time to strip back the mask of the so-called "moneychangers" and lay bare for all to see exactly what has been going on for the last two decades, and more importantly, to identify whether or not there is a kernel of respectability contained therein.

And finally, it is time to dispense with many of the calls from all corners for "hard money" and the demise of fractional lending as nothing more than an interesting philosophical exercise masquerading as an intentional (or horribly-misguided) misdirection.

Let's first define a few terms; these should be familiar:

• Principal: The amount of money you borrow for a given term of time.

• Interest: The amount of money you pay, usually expressed as a percentage, to cover three risks and costs - the risk you will not be able to pay the principal, the risk of currency devaluation and the demanded profit on the loan by the lender.

• Collateral: The item or items you post with the lender to secure your indebtedness.  While "collateral" in the broadest sense includes anything that could be seized after a judgment should you fail to pay (including your labor at subsequent points in time), for the purpose of this discussion we will limit the term "collateral" only to that specific physical, tangible property you post to secure a specific loan, explicitly excluding anything of a speculative nature (such as your ability to earn money in the future.)

• Monetary Base: The monetary base of all credit-based monetary systems is the sum total of all unencumbered assets against which one is both able and willing to borrow.  (No, it is not "M1", "M'" or any such nonsense.)  If you run into a so-called "Economist" who claims to have letters after his name yet makes the argument that "base money" (or any such thing) is the monetary base in a debt-based system find out where he got those letters from and petition them to revoke his degree; he fails at the fundamental skill of logic and deduction, yet it is a near-certainty that he carries proof that his claimed position is wrong in his wallet (a credit card, which spends identically to the dead president it resides next to.)

Ok, having settled on definitions, we will now turn to the fundamental reality of fractional reserve banking.  Many people claim that banks "create money" or "print money."  This is not true; a bank recycles money, that is, it increases the velocity of a given amount of money in circulation, but an ordinary bank (not a Central Bank) never creates new money.

We'll start with our hypothetical bank that has no assets and no deposits, and a 10% fractional reserve requirement.  Joe walks in and deposits $10,000 and leaves.  The bank now has $10,000 in assets (cash) and $10,000 in liabilities (a book entry that says it owes Joe that $10,000 on his demand.)

Jane now walks in and wants to borrow money to buy a car.  She borrows $9,000 from the bank and posts as security the title for the car she purchased.  The bank now has exchanged $9,000 of the cash asset that it had for a piece of paper (the title to a car and a promissory note.)   Let's, for the sake of argument, agree that Jane paid half cash for the car and that it is worth far more than the $9,000 she borrowed (this becomes important in a minute.)

Now the car dealer comes in and deposits the $9,000 that Jane spent.  The books look like this:

This is where the complaint that the bank is "printing money" comes from; notice that there was only $10,000 in the beginning, but there is now suddenly $19,000 worth of both assets and liabilities. 

The "purists" will argue that both the car dealer and Joe can't come in and demand their money - its not there (only $10,000 is, not $19,000.)

This is false: The bank holds a piece of paper worth at least $9,000 and can sell it immediately into the market if necessary.  As such it CAN pay both the car dealer and Joe should they both demand their money by disposing of the asset it holds in lieu of the other $9,000 - Jane's loan.

This also looks ok from an accounting perspective - both sides of the ledger balance.  Let's keep going.

Steve now comes into the bank and opens a credit card account with a $8,100 credit line.  He immediately blows the entire line on an exotic cruise vacation.  The cruise line deposits the funds.  This is what we've got now (note that the $8,100 he borrowed was 90% of the deposit from the car dealer; I have grouped the transactions to make it simpler to follow.)

Now we have a problem.  See, the "Credit Card" loan that Steve took out is unsecured.  That is, it is nothing more than a raw promise to pay in the future, backed by nothing other than Steve's word, and what's worse, Steve immediately consumed the entire $8,100 - it's gone.

So now if the cruise line, car dealer and Joe all come into the bank and demand their money the bank has a very high probability of not being able to pay.  It may be able to sell Steve's paper (the card account) for $8,100, but that line, being unsecured, is likely going to be subject to some sort of haircut in the market - maybe a big one.  The particular "haircut" is entirely dependent on the exact state of the economy at any given point in time, along with Steve's personal financial situation.

The important point is that the asset that the bank holds from Steve is nothing more than a signature and promise.

This is unacceptable and in fact is the cause of every economic Depression featuring a deflationary credit collapse over time, as defaults begat more defaults and those defaults, uncovered with capital, cascade through the system instead of being isolated to the failed institution.  All of them.  1873, 1929 and the present mess were all caused by systemic and pernicious violation of the most fundamental rule of sound banking: One must never lend out more unsecured than one has in excess capital. 

So how could the bank have avoided this?  Simple.  Let's say that the bank had taken in capital in the form of stock issued to the public; it thus might have a balance sheet that looks like this:

Now everything is fine.  Why?  Because the shareholder equity can get whacked as required.  Let's assume Steve defaults; we now have:

Notice that the books balance, but the loss was taken out of the shareholder's hide.

"Paid in Capital" is one of several types of "excess capital" that a bank can hold.  A bank could also issue bonds and it can retain earnings; all three are actual hard cash.

Therefore, the fundamental rule is this:

No bank may be permitted, under any circumstances, to have outstanding more in unsecured lending than it has in actual excess capital.

So long as this rule is adhered to there is never a risk of depositor loss and "deposit insurance" such as the FDIC is irrelevant.  Indeed, the FDIC should exist only to cover the malfeasance of government officials who have failed in their essential task - that is, guaranteeing that the banks under its supervision never exceed their excess capital in unsecured lending.

The counter-argument - that one cannot quantify asset prices accurately and thus incursion of this rule will occur "accidentally" - is often raised.  This is a chimera - the standard is that it may never happen, and it is the responsibility of bank management to decide how close they want to fly to the Sun!  That is, the more leverage they take on, the lower the down payments they permit for their asset-based lending and the closer they run in today's market prices for the assets they hold to their excess capital the greater the risk that an economic dislocation of some sort will render them instantly insolvent and closed [This would need to be enforced as effectively as is the rule “You will be punished if you swerve across the centerline of the road into oncoming traffic.”.], wiping out the entirety of their unsecured bond and stockholders.

In point of fact any bank which has outstanding more in unsecured lending than it has in excess capital is at that moment insolvent, in that it has no security against the amount outstanding in loans that exceed excess capital.

Note that this has exactly nothing to do with whether you are on a Gold Standard nor does it have anything to do with fractional reserve lending.  In fact the Depressions of both 1873 and the 1929/1930s occurred while on "hard money".  A gold standard (or any other "hard" currency) will do nothing to stop this, because the problem has never been the fiat nature of currency - it is the fact that credit is being extended without collateral beyond the actual cash reserves of the institution in question.

Now here's the nasty: It is illegal in many states for a bank to accept a deposit while in this condition.  As just one of many examples (Nevada):

 1.  It is unlawful for a president, director, manager, cashier or other officer or employee of any bank to permit the bank to remain open for business, or to assent to the reception of deposits or the creation of debts by the banking institution, after he has knowledge of the fact that it is insolvent or in failing circumstances. An officer, director, manager or agent of a bank shall examine the affairs of the bank and shall know its condition. Upon the failure of any such person to discharge his duty of examination, he must be held, for the purpose of this title, to have had knowledge of the insolvency of the bank, or that it was in failing circumstances, and shall be deemed to have assented to the receipt of deposits while the bank was insolvent or in failing circumstances. A person who violates the provisions of this subsection is individually responsible for deposits so received, and all such debts so contracted, but any director who has paid more than his share of such liabilities has a remedy at law against other persons who have not paid their full share of such liabilities for contribution.

....

3.  A person who violates the provisions of this section, or who is an accessory to, or permits or connives at, the receiving or accepting of any such deposits, or the giving of such preferences, is guilty of a category D felony and shall be punished as provided in NRS 193.130.

Each and every bank officer and manager is not only civilly liable for any loss suffered (e.g. balances beyond insured limits) but is also CRIMINALLY liable for the acceptance of deposits while the bank they work for is factually insolvent in many of these states, including Nevada.

If The Federal Government will not close these institutions and will not act in this fashion then we must insist that the STATES do so in accordance with their legal code.

These laws exist for a simple reason: When you walk into a bank and deposit money you have a contractual understanding that it will be returned to you either immediately on demand or in a relatively short period of time (effectively on demand.)  This is even true for so-called "time deposits"; you will forfeit some amount of interest (sometimes all of it!) but if you cash a CD early they are still required to hand over your money.

If the bank does not have it nor can they raise it immediately as a consequence of lending out money unsecured in amounts that exceed their excess capital then they have committed the common-law crime of fraud; they have induced you to lend them money with a promise to repay that they know is entirely speculative in terms of their capacity to perform. Unless that is disclosed to you before you tender your funds to them they have committed fraud by concealing the speculative nature of their ability to return your funds on demand.  It is that simple and a number of states recognize this as a formal section of their legal code.

IF THE FEDERAL GOVERNMENT WILL NOT DO ITS  JOB THEN IT IS TIME FOR WE THE PEOPLE TO DEMAND THAT THE STATE GOVERNMENTS DO SO FOR THEM!

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