Comments on: How Healthy are the Banks?

By: Art

Art — Sun, 04 Apr 2004 03:18:44 +0000

The bread allegory may have some imperfections, but raised some good questions for me: If there are no covenants restricting how S uses the “funds” loaned by B, isn’t is possible that something very similar to fractional reserve lending may occur in subsequent transactions? To wit, if S exchanges 6 of his 8 loaves with the tanner for future delivery of leather, the gross assets & liabilities of their 3 person economy now add up to 14 loaves, although only 10 have been produced up to this point in time. Does this imply that: (1) “false” credit is merely the addition of another link between existing savings and future production? can “real” and “false” be described simply as past and future? (2) all else equal, esp. creditors’ perceptions of risk, won’t an increase in the number of financing transactions lower the market cost of funds, without the involvement of any financial intermediary? (3) if true, would #2 mean that fractional reserve banking and FOMC operations are not fundamentally related, despite their circumstantial proximity? Thanks

By: Kim Duncan

Kim Duncan — Fri, 02 Apr 2004 01:23:44 +0000

In repsonse to the comment above, you are clearly thinking like a banker. You do not see how your actions can feed back to affect the risk you incur. If you create money by lending on a physical asset (money that did not represent savings), you are artificially reducing the cost of capital financing that asset. That asset will, as a consequence, rise in price. You can continue to lend on a secured basis but you are doing so against assets inflated in price on account of your previous lending. You can continue to do so until there is no marginal demand for credit, regardless of how low an interest rate you charge. While you do this, remember that you are writing an (presumably, unless 100% LTV lending) out of the money put option on the underlying asset on which you are lending (at ever increasing strikes on ever inflated asset values).

Consider in today’s world the case in which one can refinance his 30-year mortgage with a 3% “equity” retention (probably paper gains). The borrower has really in essence paid a 3% premium for a call option on the property. The bank owns the house (for a split second). He then repackages the mortgage in a pool which he gets guaranteed by Fannie Mae, after having the mortgage wrapped by a mortgage insurer from the 97% LTV level down to the 80% required by Fannie Mae. The bank makes a bid-ask spread. The owner of the house is really the mortgage insurance company. The lender is pension fund that has bought credit protection from Fannie Mae. The bank buys unsecured debt from Fannie Mae which is posts at the Fed against window borrowings. The bank also buys credit protection on an n-th to default basket from the same mortgage insurer who essentially owns the house, from a risk perspective.

The mortgage insurer is leveraged 15:1. It costs him 100% of his exposure to foreclose in the absence of house price appreciation. Fannie Mae, which is taking the mortgage insurers credit risk, is leveraged 84:1. The bank, who has credit exposure to both Fannie Mae and the mortgage insurer is nominally leveraged 10:1 but that does not include gap risk associated with its off balance sheet transactions.

Get the picture? Asset lending is not risk free.

By: Mike

Mike — Tue, 30 Mar 2004 09:26:16 +0000

While I enjoyed the article, I always come away from these “banks in trouble” discussions with an empty feeling. If I ran a bank and could put claims on real assets with money that I could create at will, I fail to see how it would even be possible to get into “trouble”. It seems to me that the worst that could happen to me is that I would end up with a lot of real assets that someone else had to work to create while all I would have to do is create “money”. Maybe the trouble would arrise when I accumulated more assets than I could manage, not exactly a bad problem to have.

By: Jonathan

Jonathan — Mon, 29 Mar 2004 15:03:44 +0000

If capital investment backed by the pool of current savings is understood by Austrian’s to be the source of true wealth generation, is it not possible that there is scope for some wealth enhancing higher level of current capital investment, the increase being backed by future savings, themselves being the result of said investment?
This sounds somewhat circular to me and I am sure there is a flaw but I can’t pin it down.

By: Pete

Pete — Mon, 29 Mar 2004 10:50:39 +0000

While I thought the article was on the whole well conceived (as are most articles by the author), the “baker” analogy was poorly done, and “good versus false credit” could have been explained better. Likely be explaining the gap between a free market interest rate, and a FED manipulated one more clearly.

The idea of “providing support” for the shoe maker was the most convoluted. People don’t lend bread, and they really never did. While the selling of the bread for “future shoes” was a sort of credit, it is not a very clear analogy. Credit does not normally “sustain” people, it is used for investment by producers. Eating is not clearly “investment” behavior. Had the shoe maker traded the bread for some sort of good used in the production process it would have made more sense. Staying alive to work by eating bread does not translate directly to “investment.”

This “sustaining” example is further tortured when it is used as the argument against fractional reserve banking. While I am a 100% reserve guy, I am also quite aware that a loan from a fractional reserve bank will allow me to purchase the goods nearly as well as from a 100% reserve bank. It is the depositors, and the people who accept the fractionally backed money that ought to worry. As those taking out the loan will likely be quickly exchanging the money for real goods. The holders of fractional reserve currency are those who ought to be most worried.

By: Stefan Karlsson

Stefan Karlsson — Mon, 29 Mar 2004 07:55:22 +0000

A very good and interesting article. However, I do not agree that tax-financed public spending have as bad effect on savings as deficit-financed public spending. To assume that taxation aside from direct taxation on savings would effect the savings rate we would have to assume that the receivers of public spending have a higher time preference than the tax payers. This is by no means necessarily true.
Budget deficits on the other hand is clearly bad for savings since it is a direct dissaving. At best, a higher deficit will have no effect if people increase their savings proportionally on the expectation of higher future taxation. But a much more realistic assumption is that people will take very little consideration of the risk of higher future taxation, especially since noone knows whose taxation will be increased or whose spending projects will be reduced. We can see this in the continued fall in household savings rate despite the sharp increase in the U.S. budget deficit.