There’s no real start to any story except to look back as far as you can go but no one has time for that. I could start talking about the post WWII economic settlement, the war in Vietnam and how that precipitated the collapse of the gold standard to pay for itself and then I might talk about everything which came after that – not that there’s cause and effect so much as these things made other stuff possible that wouldn’t have been otherwise. For instance, without Nixon there’s no oil shock in the 70s. Without that there’s probably no Thatcher and Reagan in the way they were. You could also talk about the rise of microprocessors and their impact on the financial markets and how, without them, modern finance doesn’t exist.
Truth is we have to start somewhere and this (long) post is, hopefully, going to explain a little of what’s going on, why I’m pretty pessimistic about the next few months (in a strictly personal capacity!) and what we can and can’t know about what’s to come.
There’s a truism in financial circles that regulators legislate for the last crisis and its from this cliché that we find the seeds of what is going to be a slow motion swirling car crash of a crisis.
I promised to keep this lay-person friendly so I won’t put references and I’ll try not to use high-fallutin language that is common in the circles in which I move.
So to start. What is a bank? There are lots of answers to this question but at its simplest, a bank is a place where we socialise money. Ok, so I’ve utterly failed already. What I mean by this is a bank is a place where lots of people come together, in trust, to put their money. They don’t just put their money there for shits and giggles (see Matt, swear words). We also want these collections of money to be used for our benefit.
What that means in practice is that a bank acts as a social hub where I can borrow against my future wealth today. I need to pay that money back but the risk I take is that I can take money today and turn it into more tomorrow so that when I repay the amount I have borrowed, I still have some left. When lots of us do this, the money going into a bank also flows out, from you to me and vice versa. This is what I mean by the socialisation of money. A bank is what we call an intermediary – it matches up those who have money to store with those who need sources of money to spend/invest.
So far, so simple.
However, when I put actual money into a bank I don’t want to leave it there forever. The actual amount of time people leave savings is, actually, far shorter than the length of time they want to borrow it. i.e. on the whole we want to wait as long as possible before repaying our debts but we want free access to the actual money we do have. This is entirely reasonable and rationale.
But it presents a bank with a problem. If the money your using as loans for other people might need to be returned to depositors before borrowers have repaid it you have something we call a maturity mismatch. Think of it like this. My sister gives me a tenner for a week. I give that tenner to my mate, Adrian, who says that he’ll use it to by a rare pokemon but it won’t be delivered to him for a month. But when it arrives he’ll sell it for £12, give me my £10 back and keep the £2 profit for himself.
On a one to one basis you can see this doesn’t work as my sister’s going to take back her money before I get repaid by my mate, Adrian. I end up out of pocket.
I also run the risk that Adrian doesn’t give me my money back…I have a risk of not being repaid.
I’m not going to get into how we price for the risk of not getting paid back nor into how I might persuade my sister to leave her money with me for longer by offering to give her a few pence each day if she does. Suffice to say there are lots of mechanisms in place to help make sure I get my money back from Adrian and to help encourage my sister to leave her money with me
These are all designed to close the maturity mismatch.
Now. Banks work because there are LOTS of people wanting to put their money somewhere. Some of them are you and me, others are companies. But none of us want our money back at the same time. We all have different periods over which we’ll leave our money, which means that, on average, the bank can lend it out without worrying that all the money it’s been given will be asked for on the same day.
I’m hoping all that makes sense so far. Please feel free to comment where it gets bewildering.
So. The next bit is that based on the fact that it’s really very rare for any group of people to all want their money back at the same time, a bank is permitted under nearly every law there is, to lend more money than it has been given. In fact, it’s weirder than this. Banks are permitted to lend money as long as they keen an amount available that would meet two possible risks.
The first is that they should have enough cash on hand to be able to absorb losses arising from people not repaying their loans. The second is they have to have enough to be able to pay depositors their cash back if they do want it. The amount they hold is sized to absorb both the above under stressed situations – when things have gone wrong and lots of losses are happening and more people than average want their money back.
You’ve got to remember that if I kept all the money you gave me witout lending it out anywhere, that’s not a bank, it’s a safe. You’ve also got to remember that if that sounds good, then you will also have to live without your credit card, mortgage, student loans, pension, insurance, healthcare, roads, computers, movies etc. etc. etc. This act of being a financial intermediary is critical for a modern way of life (whatever other criticisms you might have).
For the conspiracy fiends out there. No one designed it this way. What happened was there have been lots of attempts to make money socialised across the centuries and most of them have failed (for honest as well as nefarious reason). What people have done is learn from those failures and try to make the next attempt more robust. This is what we call emergent behaviour and although it can feel spooky it’s really just the fact that when lots of people come together communities and organisations emerge naturally from them being in close proximity to one another over time.
The current global regulations, put into place in the wake of the GFC are extremely complex but when boiled down to their simplest, suggest that banks must keep c.12% of their money in a form that can be readily returned to depositors should the need arise. (The banker in me is crying at just how actually wrong that is but it’s close enough for this post).
If I have a bank with 1 trillion dollars of cash, that means I have 120bn of cash in my buffer. I cannot just leave that cash there because what with inflation, a pound tomorrow is literally worth less than a pound today. So I need to put it work.
Silicon Valley Bank did just that and we’ll get to why it was a disaster in the next post.
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