Tuesday, 28 April 2009

Why banks might need further support

In 2006, and more so in 2007 (until "the bubble burst") houses were being bought and sold at unprecedented prices. Many other assets were similarly "overvalued", simultaneously. How is this possible?

Firstly, let's start with the money supply. It has formed a bit-part of political vocabulary since the days of Reagan and Thatcher, and in Economics a little longer. Many laymen would first think of the money supply as what exists in coins and notes.

In reality this amounts to a tiny proportion of total money. To this can be added all money that is instantly accesible, in the form of current account deposits, and overdraft allowances (you have this money, since you can spend it instantly at no great cost to yourself). A precise definition of what should and shouldn't be counted as money isn't available, instead we have several measures, which reflect things you can trade with differing degrees of ease.

Ultimately, lots of money can be created through leveraging. A bank receives a £10000 deposit, and is permitted by law to lend £9000 out. This £9000 is spent, and the recipients then deposit it. £8100 of this £9000 is lent out in the same manner as the £9000 originally. This process repeats until £100k has been deposited. This is how much can be created with leverage ratios of 10%.

In a boom, it is essential for banks (from a competitive sense) to lend as much as possible, and so they extend their leverage, keeping, say 5% in house, so that £10k can become £200k instead of £100k. As leverage increases, so does the money supply.

A similar procedure occurs with houses. Where a minimum deposit of 20% prevails, prices are low, because fewer people can afford the house, reducing demand. When this requirement is reduced to 5%, people with only a quarter of the means can suddenly afford the house. This naturally increases the price, and so encourages banks to reduce their requirements (if prices are rising, defaults are rare, so deposits are less necessary).

However, when "the bubble bursts" or faith is lost, the required deposit surges cutting the number of people who can afford a house, and therefore house's value. Now the owner can't sell, even if they wanted to, simply because the leverage requirement/limit changed.

As banks deleverage, it is important to increase their "capital base" artificially, since moving from 5-20% whilst maintaining the same money supply (important to keep the economy going) requires a QUADRUPLING of the banks stocks. And a 20% holding is required in crisis periods, because people are more likely than usual to withdraw their money at short notice.

That is why the banks needed the support they've had so far, and will possibly continue needing more. I don't have their balance sheets, and am uncertain as to how "de-levereaged" they want to become, so I can't be sure HOW MUCH money they'll need. It is also why we use the credit crunch term to describe the cause, rahter than just the nature, of the crisis.

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