By Sam Vaknin

palma[at]unet.com.mk
http://samvak.tripod.com

Banks are the most unsafe institutions in the world. Worldwide, hundreds of them crash every few years. Two decades ago, the US Government was forced to invest hundreds of billions of Dollars in the Savings and Loans industry. Multi-billion dollar embezzlement schemes were unearthed in the much feted BCCI - wiping both equity capital and deposits. Barings bank - having weathered 330 years of tumultuous European history - succumbed to a bout of untrammeled speculation by a rogue trader. In 1890 it faced the very same predicament only to be salvaged by other British banks, including the Bank of England. The list is interminable. There were more than 30 major banking crises this century alone.

That banks are very risky - is proven by the inordinate number of regulatory institutions which supervise banks and their activities. The USA sports a few organizations which insure depositors against the seemingly inevitable vicissitudes of the banking system.

The FDIC (Federal Deposit Insurance Corporations) insures against the loss of every deposit of less than 100,000 USD. The HLSIC insures depositors in saving houses in a similar manner. Other regulatory agencies supervise banks, audit them, or regulate them. It seems that you cannot be too cautious where banks are concerned.

The word "BANK" is derived from the old Italian word "BANCA" - bench or counter. Italian bankers used to conduct their business on benches. Nothing much changed ever since - maybe with the exception of the scenery. Banks hide their fragility and vulnerability - or worse - behinds marble walls. The American President, Andrew Jackson, was so set against banks - that he dismantled the nascent central bank - the Second Bank of the United States.

A series of bank scandals is sweeping through much of the developing world - Eastern and Central Europe to the fore. "Alfa S.", "Makedonija Reklam" and TAT have become notorious household names.

What is wrong with the banking systems in Central Eastern Europe (CEE) in general - and in Macedonia in particular? In a nutshell, almost everything. It is mainly a crisis of trust and adverse psychology. Financial experts know that Markets work on expectations and evaluations, fear and greed. The fuel of the financial markets is emotional - not rational.

Banks operate through credit multipliers. When Depositor A places 100,000 USD with Bank A, the Bank puts aside about 20% of the money. This is labelled a reserve and is intended to serve as an insurance policy cum a liquidity cushion. The implicit assumption is that no more than 20% of the total number of depositors will claim their money at any given moment.

In times of panic, when ALL the depositors want their money back - the bank is rendered illiquid having locked away in its reserves only 20% of the funds. Commercial banks hold their reserves with the Central Bank or with a third party institution, explicitly and exclusively set up for this purpose.

What does the bank do with the other 80% of Depositor A's money ($80,000)? It lends it to Borrower B. The Borrower pays Bank A interest on the loan. The difference between the interest that Bank A pays to Depositor A on his deposit - and the interest that he charges Borrower B - is the bank's income from these operations.

In the meantime, Borrower B deposits the money that he received from Bank A (as a loan) in his own bank, Bank B. Bank B puts aside, as a reserve, 20% of this money - and lends 80% (=$64,000) to Borrower C, who promptly deposits it in Bank C.

At this stage, Depositor A's money ($100,000) has multiplied and become $244,000. Depositor A has $100,000 in his account with Bank A, Borrower B has $80,000 in his account in Bank B, and Borrower C has $64,000 in his account in Bank C. This process is called credit multiplication. The Western Credit multiplier is 9. This means that every $100,000 deposited with Bank A could, theoretically, become $900,000: $400,000 in credits and $500,000 in deposits.

For every $900,000 in the banks' books - there are only 100,000 in physical dollars. Banks are the most heavily leveraged businesses in the world.

But this is only part of the problem. Another part is that the profit margins of banks are limited. The hemorrhaging consumers of bank services would probably beg to differ - but banking profits are mostly optical illusions. We can safely say that banks are losing money throughout most of their existence.

The SPREAD is the difference between interest paid to depositors and interest collected on credits. The spread in Macedonia is 8 to 10%. This spread is supposed to cover all the bank's expenses and leave its shareholders with a profit. But this is a shakey proposition. To understand why, we have to analyse the very concept of interest rates.

Virtually every major religion forbids the charging of interest on credits and loans. To charge interest is considered to be part usury and part blackmail. People who lent money and charged interest for it were ill-regarded - remember Shakespeare's "The Merchant of Venice"?

Originally, interest was charged on money lent was meant to compensate for the risks associated with the provision of credit in a specific market. There were four such hazards:

First, there are the operational costs of money lending itself. Money lenders are engaged in arbitrage and the brokering of funds. In other words, they borrow the money that they then lend on. There are costs of transportation and communications as well as business overhead.

The second risk is that of inflation. It erodes the value of money used to repay credits. In quotidian terms: as time passes, the Lender can buy progressively less with the money repaid by the Borrower. The purchasing power of the money diminishes. The measure of this erosion is called inflation.

And there is a risk of scarcity. Money is a rare and valued object. Once lent it is out of the Lender's hands, exchanged for mere promises and oft-illiquid collateral. If, for instance, a Bank lends money at a fixed interest rate - it gives up the opportunity to lend it anew, at higher rates.

The last - and most obvious risk is default: when the Borrower cannot or would not pay back the credit that he has taken.

All these risks have to be offset by the bank's relatively minor profit margin. Hence the bank's much decried propensity to pay their depositors as symbolically as they can - and charge their borrowers the highest interest rates they can get away with.

But banks face a few problems in adopting this seemingly straightforward business strategy.

Interest rates are an instrument of monetary policy. As such, they are centrally dictated. They are used to control the money supply and the monetary aggregates and through them to fine tune economic activity.

Governors of Central Banks (where central banks are autonomous) and Ministers of Finance (where central banks are more subservient) raise interest rates in order to contain economic activity and its inflationary effects. They cut interest rates to prevent an economic slowdown and to facilitate the soft landing of a booming economy. Despite the fact that banks (and credit card companies, which are really banks) print their own money (remember the multiplier) - they do not control the money supply or the interest rates that they charge their clients.

This creates paradoxes.

The higher the interest rates - the higher the costs of financing payable by businesses and households. They, in turn, increase the prices of their products and services to reflect the new cost of money. We can say that, to some extent, rather than prevent it, higher interest rates contribute to inflation - i.e., to the readjustment of the general price level.

Also, the higher the interest rates, the more money earned by the banks. They lend this extra money to Borrowers and multiply it through the credit multiplier.

High interest rates encourage inflation from another angle altogether:

They sustain an unrealistic exchange rate between the domestic and foreign currencies. People would rather hold the currency which yields higher interest (=the domestic one). They buy it and sell all other currencies.

Conversions of foreign exchange into local currency are net contributors to inflation. On the other hand, a high exchange rate also increases the prices of imported products. Still, all in all, higher interest rates contribute to the very inflation that are intended to suppress.

Another interesting phenomenon:

High interest rates are supposed to ameliorate the effects of soaring default rates. In a country like Macedonia - where the payments morale is low and default rates are stratospheric - the banks charge incredibly high interest rates to compensate for this specific risk.

But high interest rates make it difficult to repay one's loans and may tip certain obligations from performing to non-performing. Even debtors who pay small amounts of interest in a timely fashion - often find it impossible to defray larger interest charges.

Thus, high interest rates increase the risk of default rather than reduce it. Not only are interest rates a blunt and inefficient instrument - but they are also not set by the banks, nor do they reflect the micro-economic realities with which they are forced to cope.

Should interest rates be determined by each bank separately (perhaps according to the composition and risk profile of its portfolio)? Should banks have the authority to print money notes (as they did throughout the 18th and 19th centuries)? The advent of virtual cash and electronic banking may bring about these outcomes even without the complicity of the state.

Until recently, he served as the Economic Advisor to the Government of Macedonia.

Visit Sam's Web site at http://samvak.tripod.com

Published - December 2005