The real banking problem

The European Central Bank together with the European Union have commissioned a system of stress testing for European banks. 

It will come as no surprise that but for a few token small bank failures everyone has passed. Banks can only work if they have the confidence of the public, they had to pass or the system would have collapsed. The fundamental failure of the stress test was not to assume there would be a major sovereign default in the next five years. I know of no serious economist who does not believe Greece will default, perhaps others. So the exercise was like testing a bridge built for HGVs with family cars.

Yet the problem with our banks goes further it is the phenomenon known as fractional reserve banking.

At the slight risk of over simplifying, the banks of yesteryear commercial and federal, would back loans or bank notes with a commodity, usually gold or silver. The 1944 Bretton Woods agreement really saw the last of this system internationally. It might amuse those of you with antique bank notes to see the words “I promise to pay the bearer, on demand the sum of one pound in gold” etc etc. 

Paper money is, of course, intrinsically worthless. It is legal tender by compulsion. Governments manufacture it, in much the same way Andrex produce lavatory paper, and eventually its value will be the same. The Weimar republic found this out in the 1920s and Zimbabwe is experiencing the same phenomenon as I write.

Commercial banks, with complete collaboration from national reserve banks, have now adopted this  fractional reserve system. This simply means if a depositor opens an account with the ‘Bank of Neverpay’ they will lend it on to maybe three or four borrowers. In fact, they are lending money they simply do not have. Creating money out of thin air like a children’s conjurer. In any other walk of life save banking it would be illegal. Try selling the same car to three different people and see how long it is before the police knock on your door.

They then simply hope the depositor or depositors do not want their all money back on the same day. Of course this is bound to go wrong periodically. Witness the run on the bank at Northern Rock in the UK. Banks are built on confidence. If everyone realised that the bank does not have their money anymore they would panic. Now instead of the regulatory authorities and the government outlawing this practice as they should do, they have underwritten it with a new tax payers’ guarantee. Yet again the prudent underwriting the imprudent. 

The politicians try to cover their tracks on this by kicking up a fuss about bankers’ pensions and bonuses which is a colossal red herring. (Former chairman of RBS in the UK) Sir Fred Goodwin got his massive pension in spite of everything because the government bailed out his bank with your money, instead of putting it into receivership which is what they should have done. None, I mean none of the new regulations are going to stop any of this happening again. 

Depositors are lenders to the bank. It is not a ‘no risk’ game. A commercial bank is a risky investment; deposits, bonds, equity it matters not, your investment just enjoys a different order of preference when the receiver inevitably comes in. Extraordinarily laymen, i.e. most politicians, public service broadcasters and regulators have put the recent debacle down to ‘laissez faire’ capitalism. It is no such thing. The problems have been caused by spendthrift governments, bloated public sectors, flawed banking systems and hopeless regulation. It is ‘state capitalism’ or what used to be called mercantilism.

Perhaps if we taught practical economics in schools the future electorate could punish perpetrators of monetary fraud at the ballot box and avoid future catastrophes. The moral hazard is enormous when the tax payer is commanded to underwrite an investment. What about BP shareholders? Where does it end? What we need is clear blue water between custody and investment. If you are prepared to accept minimal interest for safe keeping a bank should ring fence it and not lend against it to all and sundry often with a woeful lack of due diligence. 

The re-capitalization of banks by buying government debt with new printed money sourced by government, sometimes called ‘quantative easing’ or ‘asset purchase’ is another smoke and mirrors gambit designed to fool the ignorant and stupid. It is like giving an alcoholic a large whiskey in the morning to stop his hands shaking, it will do just that but the liver damage will kill him later.

This problem has not gone away with the stress tests as I fear we will all find out sooner rather than later.

Godfrey Bloom is a retired fund manager and the EFD Coordinator on the Economic and Monetary Affairs Committee in the European Parliament.