Thursday, May 3, 2012

Banks at fault

A large part of the problem with the world economy lies with major banks. I don't mean domestic banks offering current and savings accounts for consumers; but commercial and investment banks who lend money to businesses and governments and - at the same time - buy and sell shares and offer all manner of so-called financial instruments.

When they first formed, banks were there to lend money to those who needed it - such as farmers with a poor harvest, parents needing funds for a good wedding, or a merchant who needed to buy stock to sell - and charged a fee or interest. In Europe, many bankers were Jews as due to religious prejudice they often not allowed any other 'respectable' trade. And lending was associated with usury and deemed below the dignity of the upper classes who could have afforded to operate them. Soon banks were lending to kings to fight expensive wars, such as the crusades. Where possible, banks demanded security in the form of assets: a cow, a house or future tax revenues. Initially, the flow of money was largely the initial capital supplemented by the interest charged or the defaulted security.

Later, bankers wanted to lend more than they had, so 'financial instruments' were invented. The recent (2008) financial disaster was laid in the 80s when domestic mortgages were 'securitised'. That meant banks could bundle mortgages and trade them with each other. Initially, it increased the amount banks could lend.  But, as with the US Fannie Mae, many bundles of mortgages included large percentages of so-called sub-prime, high risk mortgages. But as the bundles were re-bundled and sold on, nobody had the time to read all the documentation (which presumably spelt out the risks) much less take them seriously  The net result was: 
1. A large number of Western banks ended up owning a lot of high risk 'assets'
2. The total value of these so-called assets were n times the face value, never mind the risk-discounted real value.
3. When some mortgage holders started to default; the whole 'pyramid' scheme was exposed for what it was and the whole house of cards (pun intended) collapsed.

Roll forward to the Euro crisis. Many countries borrow up to a high % of their GDP. But some countries borrowed well above a single year's GDP, including Greece, Spain and so-forth. How did this happen?  The same investment banks were involved. They encouraged the finance ministers by offering what looked like cheap money with long life cycles. Once again, it took one country to look like it couldn't meet the interest payments and, once again, the pyramid started to collapse - though for the short term it is being propped up.

So, my bottom line is that whereas banks were and are a valuable institution, they have been allowed through various national and international deregulation to become gambling houses, where the stakes, risks and rewards are high. Not only are they now endangering world economy but also subverting things like - in the US and UK - causing the best and brightest from universities to go into banking disproportionate to the value add, instead of into engineering and manufacturing.

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