Don’t expect banks to lend again anytime soon

As the world faces an unprecedented economic crisis, there is a fundamental error in most policy-makers’ assumptions: they see banks as financial intermediaries.

In this view, banks are simply intermediaries, charging for connecting surplus capital with productive opportunities. Essentially, it sees them as neutral actors in the economy. That is the Walt Disney version of banks and it is almost completely a lie.

The stakes are high. And dangerous. Continuing with this charade is probably the difference between a recession and a depression.

The fairy tale view

Here is what most global policy-makers are doing to fix the economic crisis caused by the Coronavirus.

1. Reduce the interest rates charged to commercial banks.

2. Print money, the vast majority of which is made available through the banking sector.

The idea is that low interest rates and additional money will flow through the banks into the real economy.

However, the data doesn’t support these assumptions at all.

What history tells us

Following the Tech Bust in 2000 and the Great Financial Crisis in 2008, policy-makers employed a similar strategy: they reduced the cost of money and made a lot more money available. To banks. With the idea that this money would make its way into the real economy. Because banks are just helpful financial intermediaries.

Here is what really happened.

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Where did all of this new money go?

Most of it went to the banks.

The psychology of banks is not mysterious; they act like you and me. If the future is uncertain, they keep their money close. If you have just had a financial hit, you work on damage repair. You don’t go out and spend again, regardless of whether interest rates have dropped. If someone throws some cheap money your way, you put your own house in order first before you start to make investments again.

What are banks really?

Banks are active investors in the economy.

They make their investments in a unique way: by being monetisation entities. By granting loans + deposit accounts to borrowers, they give them purchasing power today in return for repayment tomorrow.

If borrowers don’t repay their loans, then banks need to repair this damage before they will lend again.

What the future is likely to bring

Here is what the next 5 years will bring, if banks act the same as they did after the Great Financial Crisis in 2008.

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What are the implications?

If banks were mainly financial intermediaries, then monetary policy would be more effective. But they aren’t. So, it isn’t very effective. In fact, monetary policy is more highly correlated with stock market performance than with bank lending. If you want to inflate stock prices, monetary policy is the tool for you.

Here is the likely policy effect

1. Banks are unlikely to lend again until their balance sheets are repaired.

2. The lack of lending will increase the chance of a depression and prolong the pain in the real economy.

3. The War on Savers will continue.

A more in-depth understanding of banks

The main thing to understand about banks is that while most of their assets (loans) have a finite life, like, say 5 years, the bank itself is correctly conceived of internally as a perpetuity. It is basically an on-going bundle of expected future loans, converting future cashflow streams into purchasing power today. This is its monetisation role.

So, you can think of valuing a bank, or a business unit of a bank, using a perpetuity growth formula, as set out below.[1]

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Where,

CF is the expected cashflow in the period (either t0 or at the start of some Terminal Value period)

r is a discount rate, the cost of capital

g is the expected future growth rate

If the perpetuity is for a future period, then the derived value needs to be discounted back to a present value.

Banks have a perception of their own value and adjust their actions accordingly. People are the same. If you feel good about future economic prospects, feel secure, feel positive about the potential for continued employment, a raise or a bonus, you are more likely to loosen the purse strings and spend now. If you feel insecure about the future, you are likely to conserve your funds.

For the bank, what drives their actions is “g” in the formula. That is their perception of the future. The term “g” has significantly greater influence on bank lending volumes than the term “r”. This is one of the reasons why typical central bank policy action is so ineffective when it comes to aggregate lending in an economy. The correlation between r and aggregate lending is low. The correlation between banks’ perception of g and aggregate lending is high.

Modern, fractional reserve banking is an inherently risky activity.

Here is why:

1. The core philosophy of fractional reserve banking is based on dishonesty. The bank tells depositors that it is their money, sitting in their account, and they can have it back at any time. At the same time, the bank lends most of the money to borrowers or uses it themselves, including as an input to their own credit money creation. The fundamental premise of fractional reserve banking is built on a lie. This lie is then propagated by the the banks’ enablers in society and enforced by the state.

2. These banks create their own “money” today, which has current purchasing power and which they give to borrowers. The value of this money, however, is dependent on future cashflows. If these future cashflows do not materialise, recursive credit money destruction causes economic crises and means that the bank may not have enough reserves to cover the lie that they told depositors: that they could have their money back.

The structure of a typical bank is illustrated below.

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The value of “g” causes a wide variance in the estimated future value of a bank’s assets, the cards at the top of the inverted pyramid. As the amount held in reserve is small compared to the expected future value of the assets forecasted into the future, the effect is that systemic shocks in the economy can wipe out the PV money valuation of many banks. In the old days, there would (rightly) be a bank run.

In 2008, after the collapse of Lehman Brothers, many large, global banks quietly admitted to their home governments that their reserves were insufficient to cover the FV money liabilities that they had created or acquired from others, that they were insolvent. Hence, the bail-out of the banks by society, cleverly disguised by most governments through the use of euphemistic language to describe what they are doing.

Not sure what quantitative easing is? Well, it is injecting newly printed money into the banking system (not the economy). Has that prompted the helpful banks-as-simple-financial-intermediaries to lend again? No. What will cause them to lend again? Well, it will be their internal, profit-motive-driven estimate of the value of “g”. Their estimate of future expected cashflows to their assets (loans).


[1] This is a simplification and you can add many different valuation considerations. The main point here is: keep your eyes focused on “g”.

Banks' estimate of future expected cashflows to their assets (loans) will prompt them to lend again, not Central Banks' policies.
Robert Sharratt

Robert Sharratt

A former banker who has had enough of disparities in financial opportunities. Working to leave the world a better place than he found it, writing while doing it.