Sunday, Jan 18, 2009
External liabilities, the UK and Iceland
IDEAS REPEC: Why are UK Banks' Overseas Assets and Liabilities So Large?
Basically my comment is lengthy so I am posting it but is a kind of explanation for the panic last Friday.
Posted by stillthinking @ 11:20 AM (585 views) Add Comment
12 Comments
- If you do not have an admin password leave the password field blank.
- If you would like to request a password allowing you to add comments and blog news articles without needing each one approved manually, send an e-mail to the webmaster.
- Your email address is required so we can verify that the comment is genuine. It will not be posted anywhere on the site, will be stored confidentially by us and never given out to any third party.
- Please note that any viewpoints published here as comments are user's views and not the views of HousePriceCrash.co.uk.
- Please adhere to the Guidelines
1. stillthinking said...
First off I feel that the words capital and fractional reserve banking are completely misrepresented in the media.
So at the risk of repeating myself, for me, I see banking as an idealised balance sheet exercise which requires no
seed capital. A wants to borrow to pay B for something, so I write -100 in A's balance column and I write +100 in
B's column. Eventually B pays for services from A, and so eventually the debt is worked off. Of course this ignores
interest. As I have an agreement with the BoE who audit me, I can actually supply paper bank notes to B when
required should any cash flow need to take place external to the banking system. Within this system I can move money
around and do whatever I want with it, but ultimately the only real thing that can ever take place is that money is
paid from B to A for work. Hence debt and savings are opposite sides of the same coin.
Now I already said that bit a million times, so where does fractional reserve come into this system, because
fractional reserve and specifically bank capital are often mentioned in the media as being sources of funding for
lending. This cannot be true, I think this was true when we were on a gold standard, capital being gold and
fractional reserve being the amount of gold that you lent above and beyond what you actually held. However, in an
IOU balance sheet system, IOUs cannot possibly be seen as real capital and fractional reserve isn't required, as the
balance sheet doesn't care about absolute amounts. Whether A borrows 100 or 100000000 depends only on an agreement
about an arbitary price level for goods and services.
So, from this what is meant by fractional reserve. I think that fractional reserve is the amount of money held by B
which can be spent by the bank. So really the bank can spend money to A, allowing A to clear his debt, should they
wish to.
Right, going on, how can a British bank without an agreement to issue dollars enter the US loan market. Because the
problem is the actual dollars themselves, not the idealised loan system. In fact, a British bank can quite easily
write down for A -100 dollars, and B +100 dollars, but the bank cannot actually provide any paper money (of course
they can if they base themselves in America but...). So that is the problem. How can the banks get round this so as
to be based in the UK and also involve themselves with foreign lending.
My conclusion is that the requirement for dollars must be met by exchanging within the banking system (note this is
internal to banking and doesn't involve work) sterling for dollars. Where does the sterling come from? The sterling
, everything else remaining in balance, must come from "unused" money held by B. This is the fractional reserve. B
has 100 but probably never really wants to use more than 20 so the bank can pay 80.
So how does this connect to the panic on Friday? Well, for all loans in denominated in sterling, the BoE has a
completely free hand, the balance only becomes "real" as it were when it is spent. It is essentially a written down
exercise of no substance. In fact, when there was a run on NR I sometimes wonder why they didn't just print all the
money held by the bank and give the paper to the disgruntled customers, who would certainly have immediately put
that paper back into the banking system somewhere else. Maybe they didn't have enough paper on hand, whatever.
Key point, sterling denominated loans are all a balance sheet exercise and there is no need to panic, because the
BoE can certainly do whatever is necessary.
However, should there be a run on the foreign liabilities of the banks in that case the government, as guarantor,
would be forced to provide large quantities of dollars. This is not possible for the BoE. This is what happened to
Iceland. Now when the banks started dropping in value rapidly on Friday, this "guarantee", which is of course
without any meaning at all -unless- called on, looked as though it might be called on.
At that point the foreign liabilities of the UK banks would be revealed, and the inability of the UK government to
honour them because our economy is so small in comparison to the size of the debts, and so basically to the
situation of Iceland. The only way the UK could obtain enough dollars would be to issue debt or print money and
exchange this for dollars on the open market, at a time when the dollar exchange rate is against them (in fact maybe
this is why the dollar/sterling rate is what it is, because the traders know the UK banks have hideous dollar exposures backed by nothing but defaults).
In which case, Friday was a fairly big event, and the government will certainly do all the smoothing and confidence building possible this week, as we just had our first brush with national insolvency a la Iceland, which would have been triggered by the collapse of bank shares to zero value.
Ta daaaaaaaaaaaaaaaa !!! Finished.
2. d'oh said...
Interesting then that the British givernment became a large purchaser of US treasuries a couple of years ago. Accident or forward planning?
3. bellwether said...
Thanks for this post ST, very interesting and worth further investigation.
I would add a couple of fairly obvious, related, if not directly relevant points.
While there are real structural similarities between Iceland and the UK, I think we remain too strategically significant to be cast adrift by the US. As compared with other countries we have a very strong connection there and remain valuable as an outpost.
The drop in financials and in Barclays in particular was about a hedge fund shouting "Fire" when everyone in the cinema was nervy. Sell enough borrowed shares into the market at the right time and you set off a collapse and the opportunity to buy back cheaper.
4. bellwether said...
Apolgies for stating the obvious
5. stillthinking said...
Thanks for the comments Bellwether. There are some things which simply don't make any sense to me when I read the media, fractional reserve being the main one (under fiat) and also capital reserves (which I tend to think of as default insurance, or money which can never be withdrawn, kind of permanent deposit). So this is my kind of attempt to make sense of it all.
Also, I have recently realised, apart from the drop in sterling which I didn't think about, that I also never really thought about the foreign liabilities of British banks, even though Mark Wadsworth often pointed out mortgage defaults alone could not be substantial enough to sink the system.
There are still things which do not make sense to me, mainly why is sterling holding value? So any comments or disagreements will be avidly read by me. I sincerely hope you are right about the US because when one currency goes pop it would have the effect of propping up the values of those still standing, Obama, from what I have read, is not enamoured of the UK population and also to what extent would it be possible for him to intercede anyway given his domestic situation.
6. stillthinking said...
d'oh, interesting point. I am sure that GB is incapable of forward planning but it does seem fortuitous. Considering we were running a deficit at the time, it doesn't make much sense. Maybe an intervention against the exchange rate due to the relatively long period of high sterling strength against the dollar, 1:2 .
7. plato said...
Nice post stillthinking..............
I think we can safely say Iceland is a tiny economy with little of intrinsic value to back up any leverage they have created. UK although basically following the same pattern is a giant in comparison able to transfer huge debts onto its population and its future. It is not nice,but that's what is happening
The American connection and the strategic gateway to Europe as bellwether points out greatly strengthen UK guarantees,so although you make sound technical points I doubt we will follow the Icelandic route.
What is happening here is probably more part of a global strategy than anything else and I believe we are going to see this unfold quite quickly.
The UK is taking her place at the helm (with her US connection) much as it may not be liked.
8. troy said...
Hi Plato
4:52pm ~~~ plato said...
1) Nice post stillthinking ~~~ CHECK
2) able to transfer huge debts onto its population and its future. It is not nice,but that's what is happening ~~~ CHECK
3) The American connection and the strategic gateway to Europe as bellwether points out greatly strengthen UK guarantees, ~~~ CHECK
4) What is happening here is probably more part of a global strategy than anything else and I believe we are going to see this unfold quite quickly. ~~~ CHECK
5) The UK is taking her place at the helm ~~~ CHECK
except how do you define 'UK'? {in terms of 2)}
There are some head cases (myself inclined to agree with) who believe USA despite its size is still run from London and always has been.
uh oh!
9. bellwether said...
All things worth thinking about, although I sense there comes a point where gut instinct is a reasonable guide. At a very simple level I don't think the boom has been big enough to crater the whole world.
The excess while inherent in the system at all times, only really ramped as house prices spiralled out of control over the past 5 years. At its simplest I think we will have a period of contraction that mirrors and overshoots the excess but then was the period of excess really so big that its reversal is will kill the Uk/ indeed Global Economy, at some level I doubt it. I don't remember getting that much richer!
I also find it perplexing that for all the talk of economic boom, GDP growth has actually been modest in the west, artificial (asset boom and cheap imports) but ultimaltely modest.
Also for all the talk of a boom, stock markets stands in contrast to this being more or less precisely where they were 12 years ago and 40% down on their 2000 peak. The argument that markets have been in a bear market since the dot com bust is persuasive.
I think everyone is about to get a lot poorer for a long time but I sense this will be something short of what happened in the 1930's where there was eg 25% unemployment in the US. I hope!
10. stillthinking said...
For 20 million workers a 200 billion bail-out plan comes to 10K each, which is doable I suppose, but surely at the very limit. But what concerns me, there is a structural deficit in government spending on top of that even with fake high tax revenue, and pension fund liabilities as well, not to mention the appalling prospect of a government funding gap causing interest rates up. If we still have these debts when we eventually recover, then we will still have these debts with high inflation and the cost will go up to a very painful level. For me, IMO, even without all this we were heading for problems because of the private/sector imbalance and our trade deficit.
Thanks for reading.
11. troy said...
10. stillthinking said..."For 20 million workers a 200 billion bail-out plan comes to 10K each, which is doable I suppose"
?
12. troy said...
busy writing 'Ponerology and the Credit Crunch'
get back next year ~~~ won't miss much ~~~ eff all happening around here
what's happened?