Building the new order
Written by Pablo González and Pedro Nonay, trying to know how the new world will be.
Entry 4
Banks (part one)
June 3, 2023
My new context selection.
This time I have selected several recent news items to think about changes in context. They are the following:
- The G 7 has asked China to help end the Ukraine War (news here). I think this is almost a recognition by the G 7 that we are in a world of two blocs, with the G 7 being the representative of one, and China of the other. Until now, the G 7 was supposed to be the meeting of the world’s powerful countries (where they did not admit China).
Another news of clear loss of power of the West is this. Saudi Arabia offers to Zelenski to negotiate peace.
- More than 30 countries have agreed to participate in the new BRICS currency (news here). This hurts the USD in terms of its ability to remain the world’s reference currency. It is another indicator of the two-bloc world.
- The exodus of Western companies leaving Russia continues (news here). This is another indicator.
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Banks.
After the recent bank failures in the USA, as well as that of Credit Suisse, many doubts have arisen as to whether this situation can be generalized.
Therefore, I am now going to deal with the issue of the stability of the banking business (I am doing it in two entries because it was taking too long for just one). I will say in advance that we are dealing with two different problems:
- That of the short term, basically generated by rapid interest rate hikes,
- And that of the long term, which is related to the usefulness of banks’ services after the technological revolution, as well as to the problems of possible future heavy defaults (public debt and commercial real estate).
That is what I will talk about in the next entry. In this one I want to discuss some previous concepts.
As I have been doing in all the entries, I will use a colloquial and non-technical language, with the objective that it can be understood without being an expert. I apologize to those who are for the many nuances that escape any generalization.
Banks CREATE money.
Simplifying as much as possible, what a bank does is to receive money from the owners of checking accounts (the depositors), … and invest that money in loans, or in the purchase of stocks, bonds, or other products.
Here appears the first curious concept of the system. The fact is that, if Paul takes a thousand dollars to the bank to deposit them in his current account, Paul thinks that they are his, and that he can use them whenever he wants.
However, with those thousand dollars the bank has given a loan to Peter for 800 dollars. And Peter can dispose of that money.
There were indeed one thousand dollars, but now Paul can use one thousand, and Peter 800. Now there are 1.800 dollars in the economy. Therefore, … the bank creates money, even though it is not the owner of the banknote printing machine. As we shall see, this has very important consequences.
The balance sheet of the banks. TRUST.
Banks, like any other company, have a balance sheet, where there are reflected:
- The bank’s liabilities, which is where the bank gets the money it is using for its activities (because it has been left by someone else).
The fundamental liabilities are the money of the owners of current accounts, in addition to the money of the bank’s shareholders (the bank’s own funds), and the bank’s debts with other banks or central banks.
- The bank’s assets, which are the properties where the bank has invested the money it manages. Most are loans granted and shares of companies, bonds, or other investments.
As in any balance sheet, the total sum of assets must coincide with the sum of liabilities (where I get the money from, and where I have it invested). Of course, as prices of things change, the sums also change. This is solved by calling profit (or loss) the difference between the sum of assets and liabilities.
However, as is almost always the case (even if there are great auditors and many experts), the photograph of a balance sheet is a one-day thing, and with very manipulable information (sometimes even legally, and sometimes not so much). Therefore, it is necessary to rely very carefully on these balance sheets, which is the reason why audits and stress tests are carried out… And, despite being carried out, almost all the banks that fail had passed these tests with good marks a few months before going bankrupt, which makes these tests not so reliable.
It is common for liabilities (debts) to be fairly clear. You usually know to whom you have to pay how much money.
However, it is not at all clear that the assets can be sold on any given day at the price shown on the balance sheet (they may be illiquid, they may have changed price, or they may even end up in total loss of value because the client ends up defaulting on the loan).
The big problem that banks have is that a very important part of their liabilities (their debts) are the amounts that current account owners have deposited in the bank. And these amounts have no fixed withdrawal date. Depositors have the (theoretical) right to dispose of their money at any time. However, the bank has invested these ammounts in places where it cannot claim them back at a date that suits it (it cannot suddenly ask for a 30-year mortgage to be returned).
In other words, the bank borrows money from its depositors on a short-term basis, and invests it on a long-term basis.
Its objective is to pay less interest to depositors than it charges for granting mortgages (and other investments), … and to make money on that difference.
It is also the bank’s objective that depositors do not claim their money all at once. For that, it plays with statistics, as well as with the trust of its depositors that the bank is “taking good care” of their money (trust is the magic word in that business).
To see the usual structure of banks’ balance sheets, Visual Capitalist’s chart of the average U.S. bank (available here) is good.
The working capital paradox.
In accounting, working capital is the result of subtracting what a company owes in the short term from what it expects to collect in the short term.
Thus, if the working capital is positive, it means that the company is going to collect in the short term more than it has to pay, so it can meet its payment obligations in the short term. In other words, a positive working capital should mean that bankruptcy is not imminent (if accounting were a true reflection of the truth, which is highly debatable).
While it is true that there are many ways to manipulate this information, it is also true that it makes sense to look for the data, and ask questions about the doubts.
For this reason, banks look closely at the working capital of companies before lending to them.
The funny thing is that banks almost always have a negative working capital. This is because current accounts must be considered as having the right to withdraw funds in the short term, and the bank’s investments (loans granted) are amounts receivable in the long term. Therefore, banks try to avoid publishing their working capital, and come to justify that this information is not relevant to their business. I invite readers to search the internet for banks’ working capital (here is an example of the little I have found on the subject).
In other words, banks ask the companies to which they grant loans what they themselves do not comply with. And they do this because they think it is one of the guarantees of the company’s reliability. In view of this, it is necessary to think very seriously about whether the stability of the banks is reliable.
Short term. One year?
I digress here to comment on an issue that is not exactly the banks’ fault.
The fact is that, in accounting, short term is usually considered to be less than one year.
It is a long-standing custom, and one that few people question (although they should).
The origin is in agriculture. The truth is that the first time that mankind began to use writing was to keep the accounting of cereal harvests. When they stopped being nomadic, it became necessary to ensure that the harvests would supply the people until the next harvest (until the following year), and with this information, decisions could be made about imposing rationing, seeking imports, or exporting (if there was surplus grain).
I also mention that the next harvest had the cycle of the sun, so it is very clear the importance of that cycle in everything (we are “solar entities”), and it is not strange that so many religions have been dedicated to the Sun God, including the Christian religion, which calls paradise “Heaven”.
All this derived in the need to have a controlled warehouse, and in the beginning of writing, and accounting, … and civilization.
Now, if we are in agriculture, it may make sense that the working capital that the accountants keep an eye on is one year, because that is the time needed to replenish the warehouses. But if we do something else, and our product cycles are shorter, or longer, does it still make sense? I think not, but they continue to use it, perhaps because of inertia (which is one of the great forces of almost everything, as Isaac Newton advanced), and because of trust in their Sun God, even if they are not aware of it.
The banks’ sense of being.
In order to try to understand the usefulness of the “bank” concept, and the viability of today’s banks to adapt to the new times, both in the short and long term (and here I am not speaking in accounting language), it is worth looking at it from different points of view. I do so below.
Before, I clarify that everything I write below refers to the so-called “commercial banking”, which is the one that provides services to ordinary citizens. The other, “investment banking”, has different characteristics, which I may study at another time.
Banks for users.
A banking user is looking for one of the following services:
- To have their savings safely stored for them. The user is afraid to have them at home, and thinks that they are safer there, which is debatable with the current system, as we will see below.
- That they offer you places to invest your savings in order to obtain some profitability. This has not been possible in banking for a long time with acceptable returns, much less in the face of inflation.
- To be given credit when you need it. This is something that still happens, but it is increasingly difficult for those who really need it (and less so for those who don’t). This is based on the fact that, in the past, it was the banks who knew the profile of their customers and their reliability in repaying loans, which today is far surpassed by the ability of technology companies to know the profile of their customers.
- That allow you to meet your collection and payment obligations (direct debits, transfers, …). This is still very necessary, but there are more and more technological alternatives to do so.
- Being able to talk to someone you trust at the bank when you want to do something out of the ordinary. Today, for most people, it is almost impossible to do anything that is not among the services offered by the bank’s WEB. Luckily, I do have that possibility (thank you, Marta).
Banks for “non-owner” shareholders.
Shareholders who do not control the banks (the minority shareholders), what they are looking for is for their shares to increase in value, and for the bank to make profits and distribute dividends.
In terms of value for investors, to give an example, Santander bank traded in 2014 at more than €7 per share, and today it is trading at €3.19. It cannot be said that it has been a good return on investment.
As for profits, given the current situation due to inflation and interest rate hikes, we will see below that they are not very likely. And, without profits, dividends are not very likely.
The truth is that it does not look very interesting to be a “non-owner” shareholder of the banks.
Banks for governments.
The government has (or perhaps had) a very important ally in the banks. For several reasons:
- Banks allow the government to borrow. They help it “place” its bonds. And the government “owes them a favor”, in addition to owing them money.
However, the current instability of banks, in addition to the risk of governments defaulting on their bonds due to high public debts and government deficits, makes it increasingly difficult for banks to help governments place their debt (unless the banks are nationalized).
- Because of what I said above about banks “creating money”, banks can help to increase or reduce the money supply (the famous M2). This is very useful for governments in their fight against inflation, although, given the current results, something is not working well.
- Banks allow the government to monitor, or even seize, the wealth of citizens. They are an effective partner of the police, and of tax collection.
The above, being true, that itself is an incentive for citizens to take their money out of the banks and put it in less “seizable” places, which is a classic argument of cryptocurrency users. And, … if people end up taking their money out of the banks, … the banks go bust. So, that theoretical utility for governments is more harm than good for them if they use it across the board.
- Since banks have to invest a lot of money, governments often ask them to collaborate by investing it where the government prefers at any given time. They call it strategic ventures, ESG targets, or whatever it is at any given time.
This has been very true, but, in the current difficult situation of stability of banks, they can do less and less “favors” to the “ideologies” of governments, and are more and more obliged to defend the viability of “their house”.
The fact is that banks are (or were) very useful for governments. Of course, governments always have to be on the edge of the limit that the bank does not control them (which is something that happens many times); and banks have to be on the edge of the risk that the government wants to control them through nationalization (which is a risk that was not considered too much before, but is becoming more and more real).
Banks for the “owner” shareholders.
As for the shareholders who really control the bank, their main profit is above the profitability of their shares.
The fact is that, with little money invested by the controlling shareholder, they control the entire investment mass of the bank, which gives them a lot of power.
To see that “little money invested”, it is enough to remember that the shareholders’ equity (shareholders’ money) is less than 15% of the bank’s balance sheet, and that few bank boards of directors account for more than 10% of the share capital, i.e. less than 1.5% of the money the bank manages.
These controlling shareholders of the bank may lose money on the value of their shares (or gain little), but they have access to a lot of privileged information, which allows them to invest their own money in projects that will be profitable (because they know that the bank will give them financing, and that the government supports them and will change the laws that are necessary).
They can also deny financing to companies whose assets they like. So, when the company goes bankrupt, the bank takes those interesting assets in payment of debts, and sells them to friends of the bank’s owners (or to themselves).
Conclusion.
The usefulness of banks, from almost any point of view, is in serious doubt, except for the controlling shareholders.
It seems that the technological revolution is overtaking them. The system is crying out for major modifications.
I compare it to what happened to the usefulness of horses for transportation after the invention of the car. Everything had to be changed.
In addition to the reasons given above to describe the doubts of the system, there is another major risk. It is the risk that banks will begin to suffer large defaults on their assets, which would imply large losses.
There is a lot of talk about the probable default on loans offered to the part of the real estate sector that today is in the greatest danger of profitability, which is that of office buildings and commercial premises. After teleworking and Internet shopping, these buildings now have lower occupancy (lower rental income); and, after the rise in interest rates, they have higher mortgage costs (higher expenses). The consequence is losses, which can lead to bankruptcies of these real estate companies, … and to not paying the banks.
However, an even more dangerous type of default for banks is one of which little is said: the default of public debt by governments. I am not referring to the default of small and discredited countries, but of the USA or EU countries. If that happens, we would be at the “end point” of the banks. And, … given the size of countries’ public debts (at historic highs), and given the rise in interest rates, it is increasingly likely that governments will not be able to service their debts.
As this entry is getting long, I will stop here. In the next one I will talk in a little more detail about the ways in which the financial system can fail, and what can happen next.
Readings that have interested me.
In the process of writing this entry I have come across the following issues that have caught my attention. They are not related to what is discussed in this entry, but I recommend watching them.
- Because of climate change, in the future the usual climate in each place will be the one that was usual yesterday 1,000 km to the south. That will affect everything. To the climate, and also to the viability of the different cities. You can see the news here.
- China controls the market for materials to produce batteries (for electric cars and other uses) and solar panels. It can be seen here, where they provide the following interesting graph.
In the next entry I will continue with bank issues.
As always, I welcome comments on my email: pgonzalez@ie3.org