Friday, January 04, 2008

Summer reading: Why Australia's Adelaide Bank and RAMS are screaming like hell

All explained here, without reference to these Australian institutions, by John Lanchester in an excellent beginner's guide to the financial crisis in this week's London Review Of Books.

His description of how banks make money is pure gold (so to speak):

"Imagine, for the purpose of keeping things simple, a country with only one bank. A customer goes into the bank and deposits £200. Now the bank has £200 to invest, so it goes out and buys some shares with the money: not the full £200, but the amount minus the percentage which it deems prudent to keep in cash, just in case any depositors come and make a withdrawal. That amount, called the ‘cash ratio’, is set by government: in this example let’s say it’s 20 per cent. So our bank goes out and buys £160 of shares from, say, LRB Ltd. Then LRB goes and deposits its £160 in the bank; the bank now has £360 of deposits, of which it needs to keep only 20 per cent – £72 – in cash. So now it can go out and buy another £128 of shares in LRB, raising its total holding in LRB Ltd to £288. Once again, LRB Ltd goes and deposits the money in the bank, which goes out again and buys more shares, and so on the process goes. The only thing imposing a limit is the need to keep 20 per cent in cash, so the depositing-and-buying cycle ends when the bank has £200 in cash – all the cash there is – and £800 in LRB shares; it also has £1000 of customer deposits, the initial £200 plus all the money from the share transactions. The initial £200 has generated a balance sheet of £1000 in assets and £1000 in liabilities. Magic! In real life, it’s even better: the UK cash ratio is 0.15 per cent, so that initial £200 would generate £133,333 on both sides of the balance sheet.

"Now let’s consider something a little more realistic: lots of different banks, with lots of different depositors and investments, many of them interlocking and overlapping. The specifics of who owns what, and who owes what, are almost unimaginably complex. Liquidity – the ability to get hold of cash easily – is crucial to this system, because your bank will often need money at shortish notice, to buy things or repay depositors. You know that if you lend money to another bank you’ll get it back without difficulty and they know the same about lending money to you. In normal circumstances, this isn’t a problem: banks lend money to each other all the time, with complete ease and transparency, and this keeps the entire system afloat. But this depends on confidence; and it is this confidence that dried up for Northern Rock in the summer, when other banks became unwilling to lend it money, and it had to go to the Bank of England for the emergency loan which then triggered a bona fide bank run – which is what happens when the people who own the £133,333 turn up demanding their money, and it turns out that the institution is in current possession only of its legally mandated £200 in cash."

HT: New Economist