Wednesday, 29 October 2008

Capitalism in Crisis

Capitalism in crisis by Adam Buik (Part 2)

As the US Fed just said, banks make their profit out of the difference between the rate of interest at which they borrow and the (higher) rate at which they lend. The ultimate source of this profit is the surplus value, produced by workers in productive activity which capitalists who have invested borrowed capital in production have to share, in the form of interest payments, with those who have invested in financing.

In America the law divides banks into two categories: commercial banks (which can take deposits) and investment banks (which can’t). British banking legislation is less rigid.

The commercial banks (High Street or retail banks as they are called here) are banks that accept individual deposits. But they are not entirely dependent on them. They can also borrow money "wholesale", on the money market where various types of short term bills and bonds are traded, and then lend this out. Of course they have to ensure that the interest they pay on the money borrowed this way is less than what they are going to get when they re-lend it. Building societies are a sort of bank, but are much more dependant on deposits than the commercial banks.

As stated (but it’s worth repeating again and again), banks can only lend what's been deposited with them or what they themselves have borrowed. Somewhat less in fact as they have to keep some of what has been deposited with them as cash to deal with withdrawals. At one time in Britain this was 8 percent. But I'm going to assume (as this is still the official ratio in America) that it is 10 percent. What this means is that for every £100 deposited banks have to retain £10 as cash. The other £90 they can lend out.

Some people misunderstand a 10 percent cash ratio to mean that if £100 is deposited with a bank, the bank can then lend out £900. This is an understandable mistake but one which currency cranks erect into a theory, claiming that what banks do is create money out of thin air by a mere stroke of the pen and then charge interest on it. But no bank does or can do this. I repeat, they can only lend what has been deposited with them or what they themselves have borrowed.

The other main type of bank is what in America is called an investment bank and what in Britain used to be called a merchant bank. Two notorious examples would be Barings and Lehman brothers, both now defunct. While in Britain (though not in America) some of these take some deposits, most of their banking activity consists in borrowing money “wholesale” at one rate of interest and re-lending it at a higher rate. Actually, it's not money (cash) that they deal in but various paper IOUs (variously called bills, bonds, securities). In the past it was mainly trade bills on exported goods, hence the name “merchant bank”.

Since the 1990s investment banks - and indeed some of the commercial banks - have been involved in two other activities: “securitisation” and “derivatives”.

Securitisation involves converting a future stream of income into a capital sum and selling it as a “security”, or bond, yielding the stream of income as interest. This - and vice versa, converting a capital sum into a stream of income - is a calculation that insurance companies have long been doing. Marx called a capital sum calculated in this way “fictitious capital”, though a better term might be “imaginary” or “notional” capital since there’s nothing dishonest or dodgy about it. One example is the price of land, which is based on the expected future rents expressed as a capital sum. The stream of future income that banks began to turn into interest-bearing bonds were, for instance, mortgage repayments but also the interest payable on other loans. In fact, different interest streams from different loans came to be packaged together into a single bond.

"Derivatives" are so-called because they are “derived” from real assets. These are essentially bets on how the price of real assets such as commodities or shares or government bonds or currency is going to change over time. When this are not pure gambling, it can be considered a form of insurance against a company or a loan failing (by betting that this will happen). Big money can be made out of derivatives if you win the bet, but so can big losses if you get it wrong. To obviate this risk hedge funds have come into existence to, precisely, hedge the bets.

Because both securitisation and derivatives are unregulated (one reason why banks resorted to them so much), dealings in them have become known as “the shadow banking system” which is also based on making a profit between borrowing at one rate of interest and lending at a higher rate. Its value is always estimated in “trillions” whether of dollars, pounds or euros. (A “trillion”, incidentally, is only what we in Britain used to call a billion, or a million million; the English billion having shrunk from a million million to a mere thousand million.)

The money market is where the banks lend and borrow short term to and from each other, mainly in the form of short-term bills such as Treasury Bills (90-day IOUs issued by the government). The rates of interest prevailing there depend on supply and demand; the going rate is known in Britain as the London Inter-Bank Offered Rate (or LIBOR). Normally, it is influenced by the bank rate, going up and down with it. This is because, as we will see in a minute, the bank rate is the minimum rate at which banks can borrow from the Bank of England.

This brings us to the central bank, in Britain the Bank of England, in America the US Federal Reserve System. This is the government's banker, receiving taxes, paying out what the government spends, and borrowing and repaying what it borrows (the National Debt). A central bank does have capabilities and powers beyond those of the other banks, in particular it controls the amount of currency that is issued. When, from the end of the Napoleonic Wars to the outbreak of WWI, the currency was convertible into gold at a fixed amount, if the Bank of England wanted to issue currency above a certain amount they had to keep the same amount of gold in its vaults to cover it; the part not backed by gold was known as the "fiduciary issue". Now that all countries have an inconvertible paper currency all this has ended. Governments don’t keep gold back their currencies anymore, only some to settle some international payments,

The currency is no longer backed by gold but only by the government's ability to raise money by taxes. All the currency in circulation is in effect now "fiduciary", or “fiat money” as they call it in America. The Bank of England does have the power to "create" extra purchasing power by putting more money into circulation, “out of nothing” “by a stroke of the pen” as the currency cranks might put it. But, if they issue more money than would be required by the economy had there been a convertible currency, this doesn't last for long as it results in an inflation and so a depreciation of the currency, so total purchasing power is not in the end increased.

In Britain the government, via the Bank of England, doesn't actually print more money and then use it pay civil servants or for its other activities (as has been happening in Zimbabwe, for instance). It's done in a much more roundabout way. When the Bank of England wants to inject more cash into the economy it sells Treasury Bills on the money market while at the same time lending the banks the cash to buy them. The effect is the same as if they'd printed more money.

At one time the government used to try to control the lending of the other banks by varying the "cash ratio" (the percentage of deposits they were required to keep as cash) or by requiring the banks to deposit money with the Bank of England. These powers still exist, but these days the main way that the government and the Bank try to control the lending of the other banks is via variations in the Bank Rate. This is the minimum rate at which the Bank of England, as “lender of last resort” to the other banks, will lend to them. If it goes down banks can borrow money from the government more cheaply and so all other short term rates can go down too (but not always, as now it isn’t).

The "cash ratio" is not the only ratio that banks have to try to respect. There is also a "capital-to-assets" ratio. Because of the particular nature of the banking business, only a small proportion of the assets on a bank's balance sheet actually belong to the shareholders, are part of the bank's own capital. Most are what the bank has borrowed, either from depositors or from the money market. International monetary bodies such as the Bank of International Settlements in Basle and the IMF have laid down guidelines as to what percentage of a bank's assets its capital should be: it’s about 6-7 percent.

This places a limit on the amount a bank can borrow to re-lend. If a bank's capital-to-assets ratio falls below this figure it is regarded as technically insolvent. So, if this happens a bank has to increase its capital or reduce its borrowing (which will of course reduce its lending) or a combination of both. This rule is aimed, it should be noted, not at protecting depositors but at protecting shareholders since, if the bank does go bankrupt, then the shareholders stand to lose everything since any assets that the bank has have to go first to its creditors.

That's the principle but there is a practical problem: how to measure assets? Since some assets are more risky than others the various types are valued by their degree of riskiness. The more risky the higher the weighting they are given. So, we're talking about a capital-to-weighted-assets ratio. Then there is another problem. Do you value them at the value they had when they were acquired, their replacement value or their market value? Currently they are supposed to be valued at market value, i.e. what they would get if they were sold on the day. This is known as "mark-to-market" accounting and has consequences on banks' solvability when market values are fluctuating wildly.

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