Banks cream it at no risk but ours
Iam not a fan of Reserve Bank governor Adrian Orr. I believe he’s politicised the office, panders to his political masters and exercises authority well outside his mandate.
It is my wish that his dismissal is the first thing Paul Goldsmith does if he becomes finance minister.
But Orr’s correct to increase the capital ratios of our trading banks.
Banks work hard to convince us that they are conservative, prudent, and cautious with our money. This explains the Roman columns, fancy atriums and marketing budgets larger than the GDP of small African nations.
It is all a con and to appreciate this we need to understand their incentive structure. Imagine an investor who has scrimped together $1 million. It is all they have. They proceed to lend their savings out.
The return of their capital will be as important as the return from it. He will be very cautious in who he lends his million dollars to.
Now imagine that this investor only has $100,000 to play with. He sets up a bank and gets the other $900,000 from investors who demand a return of five per cent.
Our banker now has $1m to lend. If he takes a safe investment at 6 per cent he will earn $60,000 from his client before paying $45,000 to his investors.
That leaves for himself the grand sum of $15,000 profit.
However, if he lends to a slightly riskier borrower and consequently gets a higher rate, say 7 per cent, he will collect $70,000 in revenue, but his costs remain the same, leaving him with a $25,000 margin.
If he gambles big with a high-risk client and gets a 10 per cent return the same maths will show him with a $55,000 profit on a mere $100,000 of capital.
If the loan goes bad and the bank fails, everyone loses and that risk is shared equally between our banker and his investors. But if the risky bet pays off only the banker profits.
The link between risk and reward is broken.
And who, you may ask, are these idiot investors who give banks their cash to gamble with?
Why, that’s you and me. When you deposit money in a bank you are lending it your money. You are now a creditor of the banking system. Congratulations.
In a neoliberal utopia these investors would appreciate that giving cash to a bank which has an incentive to lend it to a marginally respectable property developer with a nice smile is a gamble.
They may demand security in the form of deposit insurance, or read an analysis on the financial stability of the respective banks.
None of this happens because we don’t live in a neoliberal anything. We live in a highly regulated nanny state and there is an implicit guarantee that the government will not allow a trading bank to fail.
Section 31 of the Reserve Bank Act explicitly mandates the Reserve Bank to be the ‘‘lender of last resort’’, to lend money to a failing bank.
And if we did take the time to look at the published accounts of our banks, their insolvency is laid bare.
The largest has $3 billion in cash or cash equivalents, but more than $100b in liabilities to short-term investors, or depositors.
Virtually all of their assets are loans for a fixed term and unable to be called up, either legally or practically, to meet a run on cash.
Should just four per cent of this bank’s depositors want their cash out, the bank would fail.
Except, if that did happen Orr would rush in and digitally create as many billions as required to prevent a collapse.
And when the central bank prints money it devalues the cash holdings of the rest of us. It is a form of taxation by stealth, but no less effective in impoverishing us for its invisibility.
A bank that with just $13b in equity made $2b in profits last year.
No private firm in an unregulated market can earn this sort of return, but our banks can because the Reserve Bank underwrites the risk to the banks’ investors: us.
As a consequence, we are willing to lend to trading banks at an absurdly low risk-free rate while the banks lend out on commercial terms and pocket the difference.
In our scenario, the one hundred thousand is the capital ratio; the amount of his own capital that the owner of the bank puts up.
By raising the capital ratios, Orr wants to reduce the cost to the Reserve Bank should a bank fail, and at the same time reduce the risks of a bank actually failing.
I don’t approve of a state-backed guarantee of privately owned trading banks. It is unnecessary and counterproductive. Yet that is what we have.
And if we are going to allow banks to extract monopoly rent off the bank of a state guarantee, the state is right to reduce their exposure.