Observations on the Banking System and Liquidity

There has been a lot of murky reasoning about banks and liquidity in the current economic times. Many people think the government shouldn't be handing out any money to banks, while others say that handing out the money is the only way to avoid a financial melt-down. In a way both sides are correct. Let's see if we can explain this.

Large banks are required to maintain 10% reserve capital to support outstanding loans. Put another way, a bank with a billion dollars in equity (properly reserves, but we'll use equity as it is a more easily understood concept and the principle doesn't change) can issue $10 billion in loans to worthy borrowers. The Federal Reserve System requires that banks remove non-performing loans from their equity (reserves), so if $100 million in loans default, the bank has to reduce their loan portfolio by one billion dollars. The problem for the banking system is that there is little equity left after the current round of loan losses. If nothing is done, the banks would be forced to call in all open note borrowing and sell off performing assets in addition. Calling open note borrowing is particularly harmful to the economy. The bank has to tell a customer who has never missed a payment that they have to repay the loan immediately. When the customer replies that they don't have the cash right now to do this the bank will classify them in default and reduce their capital base even further, while foreclosing on whatever assets they can get their hands on. And this is from a customer who can pay off the loan, has never missed a payment and whose only sin is to have borrowed money from a bank that made faulty loans to others. That company won't be able to borrow from another bank to repay the first bank because solvent banks will be hard-pressed to take care of their existing customers.

Several of the big banks in the US have legitimate excuses. Bank of America was solvent until the government asked them to take over Merrill Lynch. BofA had an out that let them look at the finances of Merrill Lynch and opt out by December 31, 2008. When they suggested to the Fed that the losses were far worse than expected and they wanted to opt out, the Fed guaranteed more of the Merrill Lynch loans in return for BofA keeping Merrill Lynch. The casual reader needs to understand the dynamics of this. A big bank, even one as big as BofA, doesn't want to get the Fed mad at them. BofA had no real choice in taking over Merrill Lynch. They will receive a lot of the bail-out money, not because they made bad loans, but because they helped the Fed bury a hideous problem.

The Fed is hoping that pumping equity into the banking system will keep the banking industry from calling loans and allow them to make new, credit-worthy loans to keep the economy going. Will this strategy work? We don't know yet. The old adage is that the Fed pumping money into the system is like pushing on the string of a balloon. If there's helium in the balloon, it will go up. However, it is clear that if we allow the banking industry to implode, no one will get any new loans and a lot of people will have existing loans called in. The result will be a liquidity crisis of major proportions. Pushing on the string doesn't guarantee the balloon will rise, but is the best bet we have.

When dealing with a crisis such as we have, speed is more important than accuracy. Pumping enough money into the system so that no credit-worthy borrower is refused a loan or has an existing loan called is far more important than making sure that each bank gets the precise amount of money needed. The domino effect from imploding loans is sudden and catastrophic.

The money the government is loaning the banks is, for the most part, temporary. They expect to have most of it repaid. And it is easy to see how. Banks can borrow from the Fed for the historically unbeatable rate of .25 percent. They can loan money all day to credit-worthy borrowers for 5 percent. We have never seen a ratio between cost of funds and loan rates of 20 times. Banks will make huge amounts off our loans. Unfortunately, they need to. Assuming the world economy doesn't implode, the surviving big banks will be hugely more profitable than they have been any time in the past 50 years. Before you complain about the windfall profits of the surviving banks remember: If all the banks failed, you wouldn't get a loan for anything for the next 20 years or more. Much as we like to complain about banks, we depend on them. Without them we'd have to pay cash for all purchases.

February 1, 2009