Home > Finance and money > How a bank works: modern miracle or just a mirage?

How a bank works: modern miracle or just a mirage?

The major function of a bank is its role of Intermediation, whereby the requisite demands of lenders and borrowers are brought together for mutual benefit.

This Intermediation can be split in to two key functions for banks. The first is maturity transformation, whereby banks borrow money in the short term (e.g. instantly available deposits) and lend out over the long term (e.g. a 20 year mortgage). This places a bank in the unfortunate position of being vulnerable to a liquidity squeeze whereby lenders could withdraw deposits quicker than a bank could liberate its assets (especially if pressured to accept “fire-sale” prices). As a result of this, banks need to provide credibility and trust to lenders (i.e. shareholders and retail depositors).

In return for handling this transformation (borrowing short and lending long), banks are rewarded through extracting a profit, provided that this trust is honoured.

This maturity transformation is also known as Liquidity transformation. Creating a seemingly liquid (i.e. highly mobile) financial sector has been at the forefront of intellectual and political aspirations. We are constantly told how the global economy needs this liquidity that the banks create inorder to provide us with the lavish lifestyles we lead. If this liquidity seizes up, so will our real economy.

But does the world really need bucket loads of liquidity sloshing around? Why do we need the equivalent of one year’s global GDP to be traded twice over on a daily basis by the financial sector? What purpose is there for this relentless Liquidity Pimping?

The answer is as follows:

Liquidity = fabricated marginally-backed leverage!

In other words, the liquidity is a complete fiction. A bank acts as if it has the whole value of a fixed asset (say a mortgage on a house) at its full disposal in cash terms. Clearly in reality the cash equivalent of this asset isn’t available to it in immediate or “liquid” sense. The house hasn’t been sold to realise the cash. Therefore, the bank operates with a form of leverage that is only partially backed-up in the real world. This quote from an article about a similar issue in the 1800s explains it well:

“because money was invested in industry through the medium of securities, or fictitious capital, there was an illusion that the capital thus invested was “mobile,” or to use the modern terminology, “liquid.” The individual investor can always transform his share of stock into a sum of money – all he has to do is sell it. But Marx pointed out that this has nothing to do with the “mobilization” of society’s real capital. Money invested in heavy industry is fixed. “

Fictitious Capital (see the section “Marx on the Mobilier”)

So the whole concept of whether a society actually wants or needs this fictitious liquidity is never actually discussed. Every debate or discussion commences with the assumption that a modern society needs this liquidity. Banks may need this liquidity (in order to generate scope for leveraged profit making), but the truth of the matter is that the social benefits are greatly over-exaggerated, if not harmful. See this article Is the finance sector good value?

Now, moving on to the second key role for a bank; risk transformation. In this capacity, a bank undertakes to control or mitigate the different levels of risk that it holds as assets (e.g. loans). This takes the role of the bank trying to protect itself from the potential abuse of trust by borrowers. By choosing the word “transformation“ one is led to believe that banks can perform tangible changes to the extent of risk that they are exposed to, however a better choice of word would be risk mitigation.

This is because risk in its pure and aggregate sense is not strictly acquired by banks and then mystically detoxified into a safer level. To believe otherwise, is to assume that banks can “spread risk and somehow magically evaporate it in the vast complexity of the financial galaxy”. Banks receive the right to profit from appropriately containing or avoiding risk, not because of their ability to convert the risk to a less hazardous state. The risk still exists in the system. For more details see my ICB Submission – Nov 2010

Again, this is a fundamental misunderstanding amongst the public (and academics). We presume that modern banking is effective, neccessary and safe. Nothing could be further from the truth.

The very premises of modern banking – risk transformation and maturity transformation – are actually convoluted sleights of hand !! In reality, they can’t actually reduce risk (it can’t magically go away!) or equally create liquidity from nothing. It’s just an illusion acquired through an exploitation of the public’s confidence. In other words; deceit.

About these ads
Categories: Finance and money
  1. johnm
    May 31, 2011 at 11:29 am

    Its nice to see a bit of sense written ,you have to wonder about all the vested interests that politicians must have that overide their duty to maintain a civil society. How do we break out of this political torpor, is it possible with our current system or do ‘lawful rebellion’ have the right idea?

  2. June 1, 2011 at 8:44 am

    John

    I’ve not come across “lawful rebellion” before but will look in to it. In my mind, one of the first problems is one of informing and educating the public. Unless people properly understand the causes of our problems and the unjust actions of certain groups, then in the face of social unrest all manner of misdirected angst could end up obscuring the real crime and criminals.

    Groups like NEF andUKUncut seem the most prominent and effective at the moment, but are still highly marginalised.

  3. tvest
    June 22, 2011 at 7:42 pm

    While there’s no denying that the exploitation of/dependence on leverage has risen to suicidally absurd heights, not all “liquidity creation” is fraudulent. Given a relatively stable/predictable depositor population (at least at the statistical/demographic level) and a very basic fractional reserve banking system in which the only recognized form of bank reserves is vault cash on hand (or substitutes that are *perfectly* equivalent both in terms of certain value and immediate disposability), a fair amount of liquidity can be created risk-free simply through the process that scientists and engineers call “statistical multiplexing” (c.f., http://en.wikipedia.org/wiki/Statistical_time_division_multiplexing). Statmux is most certainly *not* just a confidence game or magician’s trick — e.g., it’s the single-most important factor that makes the present-day Internet more useful/efficient/accommodating than the old switched telephone networks that were its immediate predecessors.

    Of course no population is 100% predictable, and the future always holds surprises, so there’s no way to know the precise boundary that separates “safe” vs. “recklessly excessive” statmuxing at any single moment in time. However, just because we don’t know whether a 20:1 or maybe even 22:1 leverage ratio is safe, that doesn’t mean that one can have no confidence in any level of leverage — e.g., a bank that knows its customers and employs common sense and good judgment is very very very unlikely to ever get into trouble with a 5:1 ~ 10:1 fractional reserve ratio. it would be incredibly foolish to simply forego the possibility of a “safe” 5x-10x expansion in lending capacity based on the false belief that every kind of “leverage” is equally risky

  4. June 23, 2011 at 8:04 am

    tvest

    Thanks for the interesting reply and the introduction of “statistical multiplexing”. I don’t think that I was advocating elimination of all leverage. I think we can both agree that uncertainty and volatility must increase as the leverage ratio increases. Certainly leverage is symmetrical; higher leverage can yield higher profits and social benefits, but this comes at an increased stake if things go wrong too.

    Therefore, I’m challenging the current mantra of “more liquidity = always good”. This isn’t the case, and if I understand your comment correctly, you agree with this. Naturally this then begs the question of where does an optimum ratio exist? I would posit that an optimum ratio as certainly at a much lower end to that presently being used (i.e. between 1 and 5), plus a ratio that is correctly mediated through genuine market forces (whereas currently the excessive leverage is being underwriten by state guarantees, therefore bad lending is not being penalised or reigned in).

    You might find these two articles from the BoE very interesting:

    http://www.bankofengland.co.uk/publications/speeches/2009/speech409.pdf

    http://www.bankofengland.co.uk/publications/fsr/fs_paper10.pdf

    I hope to write more about the second article soon. The paper describes how liquidity has been generated in the banking sector mainly through balance sheet largesse, and that this is a precursor to financial instability.

  5. tvest
    June 23, 2011 at 5:47 pm

    Thanks to you also FS. Your intuition is correct — I agree wholeheartedly that extremism in the pursuit of liquidity is a great vice, if not a crime. Either way it should be sufficient to permanently and irrevocably disqualify anyone who exhibits such behavior from working in the monetary liquidity sector in any significant decision-making capacity. Ditto with respect to institutional-level, TBTF-style guarantees.

    That said, I personally don’t think the concept of an “optimum ratio” can have any meaning outside of careful actuarial-style observations over extended time periods, which implies that that “optimum” probably varies quite substantially across time and space. Although that assumption is commonly cited by champions of radical deregulation and “free banking,” history as well as recent experience provides abundant evidence that the market selects *against* the kind of individual-level judgment and prudence that would be required to make the complete self-regulation of liquidity provisioning viable. If there were some assured and sustainable mechanism capable of guaranteeing absolute transparency of all banking practices to any/all interested parties at all times in perpetuity, that might be sufficient to make a self-regulating system work. But it’s hard to imagine any of today’s financial titans accepting such conditions, voluntarily or otherwise — they know only too well that sunlight would eliminate their hyper-profitability. I guess another kind of disinfectant will have to be found — if the system is to recover, that is.

  6. June 23, 2011 at 8:23 pm

    tvest

    What a wonderful phrase “sunlight would eliminate their hyper-profitability”!

    I agree with the aspiration for a “sustainable mechanism capable of guaranteeing absolute transparency”. What exactly it would look like, I’m not sure, however I certainly have come to the conclusion that securitisation is one key pillar of instability, see this link:

    http://forensicstatistician.wordpress.com/is-there-a-fundamental-flaw-in-modern-banking/

    Some of the criticisms of Securitisation are echoed in the 2nd BoE paper referenced above. You are right to notice though that there are two very big challenges:1) to design the ideal system, and 2) to persuade current vested interests to implement such a system. But step by step we can get there!

    I’m not sure what your level of interest / profession is, but I strongly recommend the work of Peter Warburton on the subject of excessive credit creation. This link gives a taster:

    http://forensicstatistician.wordpress.com/2011/03/14/can-we-please-have-a-return-to-prudential-banking/

    Hopefully you’ll stick around and help figure this all out!

    All the best

    Hawkeye (the forensic statistician)

  7. tvest
    June 24, 2011 at 2:58 am

    Thanks once again Hawkeye. We do seem to be on the same page, c.f.,
    http://ineteconomics.org/blog/money-view/are-banks-firms#comment-127905

    Securitisation is just one of several dimensions of variation in the mechanics of liquidity provisioning that have, in combination, made it almost impossible for bankers to accurately keep track of how exposed they actually *are* at any point in time. Granted, such complexifications are perfectly understandable if one believes that liquidity is, or ought to be, infinitely extensible — and it would be perfectly natural for those whose incomes are directly tied to liquidity creation to gravitate toward such beliefs. The synthetic liquidity instrument industry has already made it possible to sustain such beliefs for a long time — and I’m afraid that that faith remains unshaken in many quarters even now.

    I think it was Keynes who said that ideas are more powerful than interests; so much the worse when when ideas, interests, and power are as well-aligned as they are today. Given the resilience of the status quo to even modest, pro-industry (or rather pro industry-sustainability) reforms, there’s no telling how much more “discomfort” will have to be meted out, and for how long, by a non-conforming reality before folks start to wonder whether that long-assumed happy alignment between their personal beliefs and their own private interests might have been a little too convenient…

    I’m not sure what my profession is either, but I am definitely interested — and I don’t expect to be going anywhere ;-)

  8. June 27, 2011 at 1:23 pm

    Tom (tvest)

    Thanks for the reply. Sorry been a busy weekend, and I’m about to go on holiday for a week so apologies if it goes a bit quiet on here for a little while. Thanks for the link to your comment. For an academic the chap doing the blog seems refreshingly inquisitive and critical. I shall try and keep up with his blogs and may comment on there from time to time, as it’s clear he is on a similar track.

    I suspect that vested interests will continue for quite a while in the UK, as the average person is still gloriously ignorant of what is going on in the world. It may take longer and sustained declines in wages and living standards before people cotton on.

    Feel free to chip in to any of the dialogues on here while I’m away (there’s a few open debates going on!). I also highly recommend David Malone’s Golem XIV blog, too, if you’ve never visited it before.

    All the best and speak soon,

    Hawkeye

  9. September 21, 2011 at 11:56 am

    Seems that some in the BIS are also prepared to acknowledge how the finance sector creates it’s own credit (i.e. generates excessive liquidity):

    “The financial system can endogenously generate financing means, regardless of the underlying real resources backing them. In other words, the system is highly elastic. And this elasticity can also result in the volume of financing expanding in ways that are disconnected from the underlying productive capacity of the economy.”

    http://www.bis.org/publ/work346.pdf

    Rough translation of the bIS paper available here:

    http://www.nakedcapitalism.com/2011/09/the-very-important-and-of-course-blacklisted-bis-paper-about-the-crisis.html

  10. Anonymous
    November 11, 2011 at 9:41 am

    Modern banking can be described in one sentence:

    “The deliberate obscuring of ownership title”

    Not only are retail depositors with a bank, actually just semi-secured creditors (more thanks to Gvt promises of guarantees than any formal / legal protection), but it seems that the big boys are at it too.

    The murky demise of MF global should raise more than a few alarm bells:

    http://www.zerohedge.com/contributed/it%E2%80%99s-official-wall-street-firms-may-legally-steal-their-customers

    “A CFTC rule allowed MF Global to use the margin and cash in customers heretofore segregated accounts to amass a risky $6.3 billion investment in European sovereign debt that backfired. Nor did Corzine have the obligation to inform any of these customers he was gambling with their money. Or that he was intending to keep all the profits for himself and his troubled firm. Nothing for the customers.

    This shocking loophole…..means that huge risks are being taken with money that does not belong to the trading firms– without the customers having any idea of the danger they are in.”

  11. November 18, 2011 at 11:46 am

    There is a simple test that can be applied to judge whether a person truly understands the nature of risk. Take the following statement:

    “There is a fundamental law of the conservation of risk. No amount of financial engineering can majestically transform or transmute risk, it merely gets temporarily mispriced, disguised or transferred.”

    True or False?

    Since the ascent of Monetarism the level of risk was deemed to be accurately determined by the interest rate. A low interest rate therefore induces borrowing by giving the impression of low risk (to both borrower & lender). But if interest rates suddenly jump up (e.g. Italian bonds!), then we led to believe that “new” information has suddenly heightened risk. We are meant to believe then that Risk has recently appeared into the system as if from nowhere!

    If the interest rate (i.e. presumed risk level) itself varies over time, then we have a volatile (i.e. risky) measure of risk!

    Given that the judgement of the level of risk, is itself risky, then surely the least risky situation for any type of borrower (whether a household, corporation or Gvt) is not to undertake any form of borrowing (especiually where interest rates are liable to change). This is because future income levels needed to pay back debts, are also uncertain (i.e. they are not fully guaranteed to occur).

  12. April 5, 2014 at 7:29 am

    The conversion to DTV has caused some confusion regarding this issue.
    Read on to find out the steps you need to follow if you
    want to install an antenna all by yourself at home.
    sepia, aqua, greyscale and green, and the capacity to not only have a great looking TV for any office or bedroom, but
    to also to enhance any gaming experience.

  13. June 5, 2014 at 10:56 am

    Nice response in return of this matter with solid
    arguments and explaining everything regarding
    that.

  14. June 11, 2014 at 1:34 am

    Hi, I do believe this is a great blog. I stumbledupon it ;) I’m going
    to return yet again since i have bookmarked it. Money and freedom is
    the greatest way to change, may you be rich and continue to
    guide other people.

  15. July 12, 2014 at 12:41 pm

    WOW just what I was searching for. Came here by searching for mesothelioma survivors

  1. No trackbacks yet.

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 )

Twitter picture

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

Facebook photo

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

Google+ photo

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

Connecting to %s

Follow

Get every new post delivered to your Inbox.

%d bloggers like this: