The banks are returning to profit, but where did it all go wrong?

The news that the major United Kingdom Banks are returning to profit is welcome. In 2008 most of them were at risk, so it seemed and most of them needed taxpayers’ money directly as an injection or indirectly as a guarantee which gave people confidence to keep their money in the banks. After nearly two years the confusion surrounding what went wrong is beginning to unravel. Banks are inherently potentially insolvent businesses.  There are two definitions of insolvency and these apply as much to the large financial institutions as they do to individual people.

The first definition is that liabilities – what you owe – are greater than assets – what you own.

This is quite simple to understand.

The second definition is that you cannot pay what you owe when you are due to pay it. You cannot pay your debts as they fall due.

Many businesses are in a permanent state of insolvency under one of the two definitions. A business can have few assets and might owe a great deal – such as a service business. However it can keep going because it has an income from the services which it supplies and can pay its liabilities – a long term loan for example which was taken out to set up the business – as and when the repayments are due.

A house owner in negative equity may be insolvent under the first definition, but if his or her earnings can cover the mortgage repayments then the owner might be insolvent under the first definition but is not insolvent under the second definition.

The reverse can apply. A business may have large assets – for example a valuable property, but may not be able to cover its debts as they fall due because it has little or no income. Then it will be solvent under the first definition but insolvent under the second definition. The same could apply to an individual homeowner who has plenty of equity in his or her home but cannot afford to pay the mortgage instalments.

Under which definition of insolvency did the UK banks fall back in 2008? Gordon Brown has complained that he spoke to one CEO of a major UK bank who was telling him that the bank was suffering a cash flow crisis, which annoyed Mr Brown because he thought it was more serious than that. That caused Mr Brown to use taxpayers’ money so as to give the UK taxpayer 80% of RBS and 41% of Lloyds TSB. This came as an injection of capital which plugged the losses that the banks had suffered and enable the banks to pay their debts as they fell due.

Whether the banks were insolvent under the first definition is doubtful, because the banks are special businesses where insolvency is always just around the corner. Banks take deposits and then lend them. They have developed a technique of lending more than they take on deposits by borrowing from other banks and institutions and by leveraging their deposits (leverage multiplies profits), but their ordinary retail customers can at any time withdraw all their deposits. If there is a lack of confidence, as there was in 2008, and customers all attempt to withdraw deposits or threaten to, then there is a run on the bank which can only be stemmed by something which increases confidence.

The traditional way of increasing confidence is for a central bank, in the case of the United Kingdom the Bank of England, to as a last resort lend to the banks who are suffering the risk of having no money to repay all the depositors, and as such the Bank of England had a role as a lender of last resort. This would have been the normal way of treating the loss of confidence in 2008. For the Bank of England to be viable as a lender of last resort it has to have a regulatory function, so that it knows what is going on and can steer the commercial banks away from excessively risky transactions.

However by 2008 the Bank of England had lost it regulatory function and was no longer a lender of last resort. That meant the banks in trouble had to apply to the government for money and when government gets involved political considerations become paramount, because the government is taking direct responsibility for its actions.

Once politics steers banking policy you will tend to find the policy moving in the direction of the prevailing political philosophy. For Mr Brown, his political affinity was towards a state dominated economy and hence, I suspect, he chose to support the banks with not just loans, but also with a large capital injection which meant that the banks issued shares to the taxpayers.

The policy recreated confidence amongst the depositors who then did not seek to withdraw their money, but also probably caused a loss of confidence in the ability of the banks to run their own businesses.

That lack of confidence still exists. Banks are still engaged in risky gambling with depositors’ money and pyramid their assets in an attempt to leverage greater amounts of value out of them.  Leverage is a wonderful thing if you are making money but bankers sometimes forget that leverage works just as effectively if you are losing money to leverage your losses to higher and higher levels because leverage multiplies losses.

2008 ended an era of “boom” which had started in 1995.That is a relatively long cycle and probably if there had been some small corrections to the boom, the crash of 2008 would not have been as drastic as it has proved to be. Ultimately you have got to blame the government of the day for the events that affected the banks in 2008. Whatever else was happening in the world every government has the duty to protect its citizens and protection from profligate bankers is just as important as protection from external threats. I suspect history will judge the government of the day as having failed in its duty.

One Response

  1. Banks are only returning to profit because they are not lending money to businesses, this does not help the economy

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: