Failed Banks for Dummies

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The above is a graphical representation of a failed bank.

The liabilities consist of deposits, which are promises the bank has made to pay out cash on demand to depositors. We can treat this as a fixed amount, and hence it is in grey. The assets are loans, some of which are performing and some are not. The blue bar represents the asset values based on the current market valuation of the underlying securities. As can be seen, the bank is in trouble, even by this metric, because liabilities are great than assets. The current approach, therefore, as been to try to shovel some money into the bank in order to lower the grey bar to the level of the blue bar and hence make the bank solvent again (recapitalisation), or else to raise the value of the blue bar by buying non-performing toxic loans at over-the-odds prices (‘bad banking’).

The problem with this superficial approach, and the reason why it hasn’t been working, is that the banks is a whole lot more bankrupt than everyone is willing to admit.

The red column represents the value of the loans based on the true worth of the underlying tanglible assets which were used to secure them.

The reason why the red and blue column have such a different height is because secured loans consist of a promise to pay x amount of money and a security – the tangible asset like a house or building or printing machines or whatever – which can be seized in case of default and sold on the market. Thus, the value of the loan depends on the value of the security. At present, those values are totally, totally wrong, due to the accountancy practice of mark-to-market valuation. See my previous post here to see how it happened.

One point should be clear. Based on any valuation, but particularly based on a fundamental valuation of the assets, this bank is worth nothing. Therefore, its shares are worth nothing. Zero, zilch. And it has no business paying its executives, or even its staff.

So what should be done? Simply, since we are interested in protecting the flow of liquidity we must protect the deposits of individual consumers. These are the people who will spend the money in their current accounts / savings accounts etc on the bread which will pay the wages of the bakers who will buy the light bulbs which will pay the lightbulb factory etc.

The only fair way to protect these deposits, without inadvertently rewarding the shareholders of the bank, is to nationalise the bank. Why? Because the bank is bankrupt. So like a bankrupt individual, the collector comes into your apartment and takes anything of value. He generally starts with the most valuable stuff first.

This is what we must also do on the asset side of the balance sheet. We nationalise, then go in and take all the assets the bank has. These assets must then be revalued to reflect their fundamental worth. Once this is done, the state is free to apportion out the business (assets and liabilities) to a new system of retail banks which has been created.

Crucially, the tangible assets used for secured lending have now be re-priced to reflect their fundamental value (so, for example, a mortgage is valued at the risk of default multiplied by the net present value of the stream of inputted rents minus physical depreciation). All future secured loans must operate under this accountancy principle, and balance sheets must be submitted for routine inspection by the financial regulator.

A simple rule on which financial instruments are allowed is all that is called for to adequately regulate credit creation: If the regulators cannot understand and price the instrument, it’s not allowed.

The reason this is so very different to what is being done now is that there is currently no attempt to revalue the tangible assets buried within the asset side of banks’ balance sheets.

In effect, we are propping up these asset values by attempting to support the current performing loans within the existing banking system.

This will not work, because the assets just aren’t worth what the failed banks’ balance sheets say they are. Even if we stabilise the banks in the short term through recapitalisation, more and more performing loans will slip into the default category, and when they do, the banks will become insolvent again.

The money for recapitalisation has to come from somewhere. It is in effect coming from the taxpayer, and so will push up the rate of default. Because the tangible assets are still overpriced, performing loans become new toxic assets just as the old ones get written off with the recap money.

In this way every recapitalisation will eventually result in more recapitalisation, until nobody is prepared to lend to the government anymore. Then the banks will fail anyway.

Better to nationalise now, revalue the entire balance sheet and start over. The shareholders and execs must lose everything. Protect the deposit holders and revamp the system from first principles.

This article originally appeared on Graham Stull’s blog, Ribbit’s World.

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