The Banking Crisis Explained (and solved?)

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Today, Thursday 17th May 2012, money is, apparently,  flowing out of Greece.  It has been for a while anyway, as those who can shift their wealth flee to safer havens.  Greece may not be in the Euro by the weekend.  Our banks may not survive if that happens.  How did we come to be in such a parlous position?


It isn't really about Greece.  It is first and foremost a banking problem.  Greece is a symptom.

Imagine a one horse town, with one farmer, one general store, one saloon with one bar stool, and one bank.  The bank has a $1,000.  The farmer comes in for a loan for seed, and the bank manager lends out the $1,000.  He's not too worried, as he knows the farmer is a good one, the land is fertile, and anyway, he knows where the money will be spent.  The farmer goes to the general store and buys seed, and the owner of the general store comes to the bank and deposits the money.  It went out and it came back in.

Let's suppose this happens seven times.  The saloon bar owner comes in and borrows to fit out the saloon with more bar stools (you need a lot of stools in bar, they are forever getting broken). The ironmonger comes in to borrow to restock and so on.  So now the bank has $7,000 in loans, and $7,000 in deposits, and the original $1,000 which keeps going around.

But, uh oh, two of those seven were people no sane bank manager would have lent to in ten thousand years.  They had defaulter tattooed across their foreheads.  The manager still lent, because he was intoxicated by his success at lending and the thought of all that commission and those juicy bonuses.  His wife was intoxicated by the thought of the fancy Parisian dresses and a new, wider verandah.  The defaulter thought, "what an idiot, to give me money".

So now the bank has seven depositors and only five loan assets, because two are never going to repay.  The bank owes $7,000, but only has $5,000 in loan assets.  The $1,000 capital isn't enough to cover the problem, especially after paying out a bit of a bonus.  The bank is insolvent.

The bank manager's solution is to keep quiet, pray nobody asks for their money in a hurry and hope that he can trade his way out of it over the next ten years or so.  He stops lending, because he already owes more than he has. He gets the mayor to deposit some of the town taxes when things get a bit tight.

Everybody starts to feel a bit poor.  The money isn't flowing like it used to.  The bank isn't lending.  It isn't going to for a very, very long time.  Everybody pretends the bank is alright, because they are terrified of what will happen if they admit the reality of the situation.

This is the problem we currently face, worldwide, on a much bigger scale.  It is more complicated, what with all the derivative instruments and packages of packages, but the core of the problem is very simple.  The banks have lent out $7,000 and are only going to get back $5,000.  They are insolvent. They lent subprime.  Now that the money isn't flowing, even the better borrowers are struggling to repay.  The falling tide exposes those who looked as though they were swimming, but were really stuck in the mud, just keeping their heads above water.  Greece for one.


There is only $5,000 of good loan assets. $7,000 is owed.  Someone has to feel the pain.  There is no way out of it.  Reality has to be faced.  The longer it is put off, the more unfair the end result will be.  The wise and the wealthy will shift their money first, shuffle into the good stuff.  It is the ordinary and the poor, both people and countries, who will lose out.

So first we have to recognise the problem, in order to do something about it. Stop looking the other way and pretending. Sack the bank manager.  Declare the bank insolvent and set up a new bank to take on its loans and assets.  The existing depositors have to accept that not all the money can be paid back.  They can accept $5 for every $7.  Everyone is worse off, but no one has lost everything (the bank manager still has a nice house, with a fine verandah).

Except we aren't talking about a one horse town, we are talking about the world and global banks.  Some have been luckier than others (the town mayor bailed them out, plus they sold their bad loans to an even dumber bank manager).  All, however, are culpable.   The bad stuff was sourced in even the 'best' banks, even though that may not be where it is distributed now. People got rich shifting the bad stuff to people who didn't know what they were getting.  Worse, at the moment, the rich are still getting richer and the ordinary taxpayer is suffering.  In addition, those who borrowed are benefiting at the expense of savers, and savers will be doubly hit if governments print money to bail out the borrowers.

Here is a fairer solution. Let the banking crisis go out of control, take it off life support, so that all involved have to admit it is bust. Then reconstitute the banks, giving the depositors their accounts back with the smallest depositors taking priority. Stop recognising depositors once the limit of the assets has been reached( first '$5,000' in our one-horse town). The losers will be the largest depositors,  those best placed to stand the losses and those most likely to have benefited. These larger depositors can be recognised as having an interest in the bad loans and assets, to the extent that they have any value.

An important benefit will be that the reconstituted banks will be in a postion to lend, so that the world economy can pick up again.



Last modified on Monday, 21 May 2012 11:15

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  • Comment Link FDPO Monday, 28 May 2012 11:44 posted by FDPO

    The problem with nationalisation, apparently, is that the government and civil servants cannot help interfering in areas outside their competence. So even if you sacked the boards and replaced them with people from the next level down, how would you stop the government from making a mess? Perhaps by a) keeping the period short, b) writing in an arms length agreement and c) retaining an element of shareholder interest.

    Separately, the problem with appointing people from the next level down is that they suffer from the same cultural issues that the previous directors had - that got us into this mess in the first place. Some serious 'pour encourager les autres' example setting required.

  • Comment Link FDPO Thursday, 17 May 2012 21:45 posted by FDPO

    Of course, a minor technical problem would be how to make sure the cashpoints were working the morning after! This could be achieved by nationalising the banks for a short period.

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