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Banking on Thin Ice

The banking system has two historic functions. The first is to make the circulation of money easier, safer and faster, by allowing depositors to pay by cheque, bank card, etc. The second is to create account money, by granting credit. The two functions are distinct, but both concern the payment of value and cannot avoid interacting.

Accounts are kept of all deposits. Small and large sums are credited and debited, moving among different accounts in the same bank or between banks. Once a day, all these movements are added up by a clearing-house, and each bank is given the state of its balance. (As the larger banks are doing business 24/24, 7/7, all around the world, the daily clearing process has lost its precision. On the other hand, computer technology makes it possible for banks to appraise their balances constantly.) For some banks, the sums credited are larger than the sums debited. For the others, the situation is reversed. Some banks have a surplus of money on their accounts. The others are in the red and must settle that debt before they can begin a new day’s business. Usually, the banks with the surplus lend it to the banks in the red.

The other function of banks is to grant credit to depositors. To do this they increase the value of deposits with virtual money. This is possible because only a small fraction of the total deposits actually moves around at the end of the day. As most of the value deposited never leaves the bank, it can be increased at will. However, as a security, banks are obliged to own collateral, such as gold, currency, bonds, stocks, real estate, etc. The value of which must be superior to a certain minimum fraction of the credit granted (currently 8%).

The interest paid on the credit granted by banks is their principal source of income. Wishing to maximise their incomes, banks face a double dilemma. Increasing the amount of credit granted means increasing the value of their collateral. But collateral is ever a fluctuating value. Stocks and real estate are particularly volatile. Their values frequently swell rapidly and deflate suddenly. And the more stable forms (gold and currency) pay neither rent nor dividends. The fluctuation of value on the market means that collateral can gain or loose value as of itself. So the problem banks face is the choice of collateral and the temptation to follow the rising market value of their collateral, by a corresponding rise in the amount of credit they grant.

The market values of the different forms of collateral rise and fall independently, each following its own particular cycle. But, every now and then, they move together in the same direction. At present, three forms of bank collateral, stocks, bonds and real estate, are valued at historic highs. The corresponding amounts of credit granted depend on these high values being maintained. It seems, however, that the three values mentioned above have peaked simultaneously. And that the desperate efforts at keeping them all up there together are doomed.

The weakest link is the rate of interest. It varies inversely to the market value of bonds. When interest rates rise, the value of bonds must drop accordingly (1). And, with inflation looming in the wake of mounting commodity prices, this two way movement seems inevitable in a very near future. And rising rates of interest will have a less immediate effect on the housing market and the value of real estate. They will also hit the stock market and credit in general, when the falling value of collateral reduces the amount of credit that can be granted (some have already called for a lowering of the necessary minimum fraction). A reduced supply that will put up the “price” of credit, cumulating with the increases due to inflation.

Rising prices and the interruption of cheap borrowing are the ordinary consequences of every credit bubble. But the cyclical coincidence of three forms of collateral, in their rise, peak and forthcoming slump, is a rare occurrence. It has facilitated an unprecedented swelling. But it also means that there are no secure forms of collateral to fall back on. As, apart from the three, currency is an obvious target for inflation. And gold is almost exclusively held by central banks and, anyway, there is nowhere nearly enough of it around.

The most likely scenario is stagnation accompanying inflation. Probably (inevitably?) for several years, as the gigantic paper structure of sub-prime junk that has filled so many balloons with hot air will not be absorbed painlessly overnight. This time the collapse will not be limited to Argentina, or the Asian “Dragons”. This time it concerns the whole Developed World. A financial turmoil of such magnitude that holding it off till after the November elections seems an impossible task. And yet, the presidential candidates have not voiced an inkling of what is brewing. No one seems to realise how thin the ice is. So how will they react when it all begins to crack?

KENNETH COUESBOUC can be reached at kencouesbouc@yahoo.fr

1. A bond labelled $100 pays $5 a year interest, that is 5%. If the rate of interest rises to 10%, then the $5 paid by the bond is 10% of only $50. The market value of the bond has been halved.