What factors lead to the failure of a bank?

[liveboy21]

When I was a young boy, I had asked my parents what I thought was a simple question.

"If a bank charges 20% for loans and only gives out 3% in interest, how can a bank lose money?" (Yeah, I made those numbers up)

At the time, I did not hear a good answer. Now, more than 10 years later, I am hoping that I have acquired enough knowledge to sufficiently tackle this question.

I would like to hear from the forum about what you think causes banks to fail. Here are some factors that I think are relevant to this topic.

- Agency Problems (exectutives making decisions that cause the bank to fail to make more money for themselves)
- Asset Mismatching (customers can withdraw whenever they want but loans will be there for a longer period of time)
- "Rouge Traders" (traders in the bank which if you believe the bank were not acting in the bank's interests and caused massive losses)
- "Bad" Government Regulations (whatever that means)
- Poor Pricing Decisions (if a bank does not charge the right amount for its services, that's probably not a good thing)

So, what factors lead to the failure of a bank? Are there examples where one can clearly see the cause behind a bank's collapse?

(Btw, this is my first post ever, so feel free to move my post or change it or whatever if I'm breaking some forum rule)

[Anaximander]

This is only my third post, so what the hey, I'll bite.

I never cared much about money and have avoided such concerns for most of my life until the '08 financial crisis planted a few seeds of curiosity. Since then, I've done some poking around.

Knowing how banks work and where money comes from went a long way towards my understanding of some of these things. Somebody posted this awhile back and I thought it was one of the most straight-forward explanations on the subject that I have come across if you have 45 minutes to kill (keep in mind I am a financial layperson):

http://video.google.com/videoplay?docid=-2550156453790090544

As for bank failures, here's my two cents: A long time ago, bank failure used to happen when a large enough number of people believed that a bank had lent out more money than it had on deposit. Customers who kept their money in the bank would panic and a run on the bank would ensue. If the bank didn't have enough money to accommodate the demand for withdrawals, then they would go out of business.

That was the old days. The way things work now is less clear to me. As far as I can tell, the central bank (Federal Reserve) acts as a "lender of last resort" in the event of a liquidity crisis. If a bank is concerned about its solvency, it can borrow money from the central bank to shore up its deposits. What I haven't been able to understand is why some banks can take advantage of this and stay in business while others are forced to shut down.

This seems (to me) to be the principal difference between some of the smaller community and regional banks that have gone under and the so-called "too big to fail" banks. Hopefully someone more knowledgeable than I am will chime in and educate us both. It may have something to do with the different types of assets that different banks hold, but there's probably more to it than that.

[CorruptUser]

If a bank lends out money at 20% (ignore all other expenses for now), but more than 1 in 6 people default, the bank has lost money. Banks all want to get as much interest as possible from the people they lend to, but are all in fierce competition with each other. If you truly are a good risk, and don't like one bank's interest rates, go to another bank. They all need you just as much as you need them, and the banker's bonuses are more or less directly tied to whether or not they manage to loan you the money.

This becomes more complicated when banks then resell your obligation to another bank, or in the early 2000s to a hedge fund (which does not hedge) or investment bank (which is not a bank). The original bank gets servicing fees, sells all the risk, and sometimes gets a percentage of the interest payments to boot. Since there is no immediate penalty to making risky loans so long as the bank does not have to hold them, well, welcome to the depression.

[Qaanol]

Knowing how banks work and where money comes from went a long way towards my understanding of some of these things. Somebody posted this awhile back and I thought it was one of the most straight-forward explanations on the subject that I have come across if you have 45 minutes to kill (keep in mind I am a financial layperson):

http://video.google.com/videoplay?docid=-2550156453790090544

I just watched that video. It is highly enlightening and very watchable. That video, or another like it, should be required-watching in high school. And again in college.

The bulk of the video is purely informative, and it only editorializes in the last 5 minutes or so. I strongly recommend everyone take the time to sit and watch it.

Essentially, the big problem is that, when a bank creates money by issuing a loan, the bank creates only the principal balance: it does not create money to pay back the interest. Thus total debt rises faster than total money supply. In fact, with interest rates being some annual percentage, total debt rises exponentially faster than total money.

[Ixtellor]

Simple answer:

1) Runs on the bank. Can becaused for many reasons, not limited to one of the reasons given previously.

Banks by law must have X% of their holdings in cash Generally (10-20%). If 50% of their depositors demand their deposits back they won't have the cash because its all tied up in loans, so the bank defaults. In reality, provided you have less than $250,000 in that bank, you will not lose your money, and it won't really impact you as the Fed and FDIC will intervene and forceable sell the bank to someone else who does have the 'cash' (Liquidity)

2) Bad investments that will result in a significant portion of those loans not being paid back.
Housing, government debt, corporate bonds, etc. (This covers several of the OP's 'causes')

There are many banks today in DEEP trouble because they loaned way to much money to european in the form of government bonds/securities.

3) Corruption. CEO embezzles, etc.


In reality if your (commercial) bank fails, you won't know it. The bank is sold privately and a new owner steps in without depositors every really knowing their bank was in trouble.

Purely investment banks are different they can fail. (See Lehman brothers). They tend to make risker investments seeking higher returns.

4) Your "Goverment regulations" thing isn't really valid. If the government imposed a law that said you must pay 4% interest on deposits and can only charge 5% interest on loans... then yes that could easily lead to bank failure. But there are no such stringant regulations.

In the old days Commerical banks had far more of those types of regulations than investment banks, but it was still loose enough to allow for profits even assuming X% of loans will fail.

Today Commerical banks can act like Investment banks (basically... don't feel like explaining the nuances) and no bank should be failing due to government regulation. I personally can not think of any government regulations in the free world that would cause a bank to fail.

Its pretty much limited to bank runs (of which there is AMPLE government support against) and bad investments.

[big boss]

Well in regards to the current Eurozone Crisis, we will take Greece for an example. Greece's debt is very high due to a bloated governmental (irresponsible fiscal policy) and a lack of revenue because no one likes to pay taxes over there and the government doesn't enforce to well to my understanding. The government has sold its debt to banks, in the form of bonds, and the banks decided to buy the debt because they didn't realize how risky it was, Greece dissembled financial information to make themselves look better and also in order to meet the criteria to join the Euro. Now Greece is on the verge of defaulting on its debt, the market thinks that the recent bailout is not enough and just merely delayed when Greece is going to default. If Greece defaults the value of its bonds are going to be basically nothing and then the banks who own these bonds are out billions of dollars. This messes up their balance sheets and dramatically lowers their assets and this could make the banks illiquid or worse insolvent. An illiquid/insolvent bank is going to spook investors and consumers and cause a bank run -----> a banking crisis.

[kiklion]

(Please verify this before moving on, I read it before but can't find source from my phone)

Further complicating issues is that the %police that needs to be held as cash can also be held as cash like products. Any product that is liquid/stable enoughto may be considered cash like. I believe sovereign debt generally falls into this category. Or perhaps you only need to have cash = to a percent of your positions, with riskier positions requiring higher collateral. This gives banks an incentive to purchase sovereign debt because it helps satisfy the collateral requirements. Many sovereign nations have credit ratings not proportional to their books because of two main assumptions, one being that the nation can always pull the wealth from it's citizens, and two that the nation can always print more money, devalueing it but not defaulting. These have been found out to perhaps not be the case.(end verification required)

Furthermore there is the rate of leveraging that is tied to collateral requirements. Say you give out 200% what you own in collateral, ignoring other costs, as long as less then 50% default you should remain solvent. However some businesses were leveraging upto 40x, that is giving out 4000% of what they actually own. This causes even relatively minor % of defaults to have a large impact on their collateral.

Another concern is about cds'. Say bank A purchased 1,000,000 of a certain governments bond. They are earning 1,000 a year in interest off of that bond. They then purchase a cds on that government paying 100 a year for insurance that if the government defaults the bank will be covered by the cds issuer in the amount of 800,000. This way the bank only has 200,000 exposed to that government. However two things have come up, one is the cds issuer may not have the collateral to cover the 800,000, the second is that that foreign government can psuedo force bank A to accept less than par on their bonds. This may not qualify as a default so the cds isn't triggered but yet the bank may only receive 40% of the original investment. A loss of 60% when they were expecting a maximum loss of 20%.

[big boss]

(Please verify this before moving on, I read it before but can't find source from my phone)

Further complicating issues is that the %police that needs to be held as cash can also be held as cash like products. Any product that is liquid/stable enoughto may be considered cash like. I believe sovereign debt generally falls into this category. Or perhaps you only need to have cash = to a percent of your positions, with riskier positions requiring higher collateral. This gives banks an incentive to purchase sovereign debt because it helps satisfy the collateral requirements. Many sovereign nations have credit ratings not proportional to their books because of two main assumptions, one being that the nation can always pull the wealth from it's citizens, and two that the nation can always print more money, devalueing it but not defaulting. These have been found out to perhaps not be the case.(end verification required)

The thing with printing more money is that only the central bank can print it, not the government. This is why central banks are usually separate from government so in theory if a government told its bank to print more bank the bank could refuse in principle. Now whether the government actually has 0 power over its central bank is another issue, usually the government has some power but not that much.

Now in the case of Europe, are any monetary union really, no government can't print money because the only entity than can print the Euro is the European Central Bank (ECB). And the ECB has a policy of not being the "lender of last resort" to sovereigns, however, it doesn't appear that this policy is being followed in practice on all occasions.

Furthermore there is the rate of leveraging that is tied to collateral requirements. Say you give out 200% what you own in collateral, ignoring other costs, as long as less then 50% default you should remain solvent. However some businesses were leveraging upto 40x, that is giving out 4000% of what they actually own. This causes even relatively minor % of defaults to have a large impact on their collateral.

Just for clarification for anyone who isn't an econ geek is solvency basically means that an entity has enough assets to cover its current liabilities, whether these assets are cash or cash like doesn't mater. The problem with loaning more money then you currently own is what happens when people start defaulting en mass.

[Zamfir]

The thing with printing more money is that only the central bank can print it, not the government. This is why central banks are usually separate from government so in theory if a government told its bank to print more bank the bank could refuse in principle. Now whether the government actually has 0 power over its central bank is another issue, usually the government has some power but not that much.

Of course governments have full power over central banks. Even for independent central banks, the government still appoints its leadership, supply the backing capital of the bank, make the laws that govern the bank's behaviour. If the government really wants the central bank to print money, it will happen. "Independence" just means the there are political traditions of not interfering with the central bank too much, so a specific government that wants to interfere has to be very certain of its political support.

[Ixtellor]

Of course governments have full power over central banks. Even for independent central banks, the government still appoints its leadership, supply the backing capital of the bank, make the laws that govern the bank's behaviour. If the government really wants the central bank to print money, it will happen. "Independence" just means the there are political traditions of not interfering with the central bank too much, so a specific government that wants to interfere has to be very certain of its political support.

While I agree with the premise that of course Governments have tools to force the banks (ie. LAWS) to print money, the Fed Reserve is pretty damn independant, and I can't actually think of any 'limiting' law. (there may be one/some on the books, but nothing is coming to mind). Also, the Fed is self financed. Member banks pay fees and it earns interest. Or were you referring to their relationship with the Treasury, or its initial formation? (my point being the fed can be self reliant today when it comes to capital)

[Zamfir]

The part where bank have to be members and have to pay dues is a legal decision, it's not that different from a tax that is used to bankroll the fed. It's surely true that they can act independently, but that's in the end by the grace of the government. If "the government" had a clear disagreement with the fed, the government would always get its way.

There's still very real power in the fed, because governments aren't unitary actors. There's congress, and the president, and parties and politicans who might have different views The system is, on purpose, set up such that you need to get those in a fair amount of agreement with each other before they can effectively give orders to the central bank.

But in the end, if there's a sizable agreement among politicians that the fed has to print money, it will happen.

[Yakk]

Lets back up to the most primitive bank with little to no government regulation. We'll make the bank honest. We'll also simplify it somewhat.

This bank stores your money for you. It gives you "letters of promise", which you can use to get money from the bank. Money in this case is probably physical gold.

You can imagine giving someone a letter of promise (for gold) rather than giving them the actual gold, because gold is bulky and heavier than paper. So these letters of promise can be used as a form of currency.

The bank could charge you to store the gold. But rather than do that, the bank makes a deal with you -- you allow the bank to lend your gold out to people, and in exchange it gives you gold. If you deposit 100 bars of gold, after 1 year they'll let you take out 101 bars of gold! (1% interest)

The bank then lends this money out to people who want gold, and ideally because they have some way of using that gold to make even more gold (or, they have gold coming to them, and are willing to pay extra to get gold now). They either lend the physical gold, or they lend out letters of credit against the gold in the bank. The people who borrowed the gold/letters of credit agree to pay back more gold later (if they borrowed 100 bars of gold, they agree to pay back 120 bars of gold in 1 year -- 20% interest).

Now, sometimes people default on those promises. But if (say) only 1 in 10 people borrowing gold default, the bank still ends up in a good situation after a year -- with 108 bars of gold, and only owing 101 bars of gold, making 7 bars of gold profit.

Even if people aren't defaulting, things can still go badly. See, the banks decide to say "you can take the money in our vaults out whenever you want!", because that encourages more people to deposit gold (and lets them lend more gold out). But what happens when everyone decides to withdraw the gold at once? Well, a bunch of it has been lent out, and the bank doesn't have enough gold to pay all of its depositors! This is known as a "run on a bank" -- what is worse it that if the bank is having problems getting gold to pay its depositors, other depositors can get angsty and want to get their gold back as well... this can bankrupt a bank that would otherwise be solvent.

The bank could, in theory, call up the people who owe the bank money and ask for their money back. But those people often have a plan to invest the gold and make money back later -- so they probably don't have the gold on hand. And liquidating the assets they bought with the gold quickly isn't going to return anywhere near their "full" value.

Another thing that can break a bank is that it is really tempting for a bank to make more loans (using letters of credit) than it has gold in the bank. So long as people trust the letters of credit to be honored, this isn't a problem -- but if people start cashing them in, the bank could be in trouble. The bank does this because in most situations, not everyone wants physical gold at once -- and by lending out more money, the bank gets more interest, and can charge lower rates, and thus out-compete other banks for loans and make more profit.

Similarly on the deposit end, banks who say "you can take your money out any time" can offer lower rates than banks who offer only term deposits.

The bank ends up being in the business of turning "short term cash" (demand deposits) into "long term debts" (mortgages, car loans, general loans), and then making money off the difference in rates people will accept. When the demand for "short term cash" spikes, the banks who own huge amounts of "long term debts" end up with a cash problem. This is somewhat similar to a run on the bank. To some schools of economic thought (Austrian, if I remember right) this is one of the main causes of economic recessions.

So this generates two ways in which an (unregulated, honest) bank can get in trouble -- a run on the bank (where short term cash value skyrockets over long term debt value), and having their long term debt assets be bad.

Regulations generally are set up to make the above things "less likely" by forcing a capital ratio on banks (limiting how much of their short term depots they can lend out, effectively). This cushions you against bad debts and limited runs on banks (which makes a run on the bank less likely!). These rules are sometimes suspended in the case where they would otherwise cause a run on a bank (where large numbers of banks are going to turn upside down at once). On top of that there are layers of accounting magic.

This recent crisis was precipitated by a bunch of "high quality" assets the banks own (AAA rated mortgage securities) going bad at once. The reserve ratios of banks required that they own some assets that where AAA rated against their riskier ones -- when their AAA assets became riskier, they had to (by law) get ahold of a bunch of new AAA rated assets to maintain their capital reserve ratios. This was problematic, because the value of their once-AAA assets had just plummeted (few people wanted them once they where no longer AAA), which made it hard to raise the capital to keep their reserve ratios intact. As banks threatened to fall over, other AAA assets where running the risk of turning sour, which would make even banks not directly exposed to the mortgage problem teeter in similar ways (ie, a bonk from another bank, where the other bank's assets are exposed to the mortgage problem). Because it was exceedingly hard to track down where the problem would spread to, every bank started cutting back on their loans to other banks. Which means a bank that needed a bit of cash right now before they liquidate some other asset couldn't get it cheaply (they would have to pay high interest rates for it) -- and any bank that paid high interest rates for cash looked desperate, which would encourage people to withdraw cash from it, which...

[Qaanol]

Yakk, you pretty much covered the first half of the video that was linked in the second post in this thread. Another major point covered in that video has to do with fractional lending:

You deposit $1000 into a bank. The bank is allowed to lend up to $900 based on that money.

I take out a loan for $900, and deposit it into a bank. When that happens, no money is taken from your account, nor any other account. My account is simply increased by the amount of the loan.

Now your bank account reads “$1000” and my bank account reads “$900”. There is more money in existence than there was before I took out the loan. The loan created money, to the tune of $900. It also created debt. I will have to pay back interest. Let’s say the interest is as little as $200 over the lifetime of the loan.

The bank I deposited $900 into is allowed to make a loan of up to $810 based on that money.

Someone else comes and takes out a loan for $810, and deposits it into a bank. Now your account reads “$1000”, my account reads “$900”, this other person’s account reads “$810”, and so on with $729, $656.10, $590.49, etc.

The total amount lent, hence the total amount in various people’s accounts, is a geometric series summing to $9000. That means $9000 was created by these loans. You started this by depositing $1000, and now there is $10,000 in existence.

In other words, you deposited $1000, and now the banking system as a whole is collecting interest on $9000 of loans. Also note that your $1000 came into being from a loan at some point as well.

In this example we said the total interest to be paid on $900 was $200, which means the total interest to be paid on $9000 is $2000. This means the total amount that has to be paid back for these loans is $11,000. The process of lending, based on your initial $1000, created $9000 in new money and $11,000 in new debt.

Usually loans are long-term debt, and the interest adds up to about the same amount as the principal. The specific values aren’t important though, what matters is that more debt is created than money.

Since money is created as debt, and more debt is created than money, it is necessarily the case that not enough money exists to pay off all the debts. The only way for the system to remain viable is for the banks to collect their interest payments, then turn around and spend that money again so it can be used to make more loan payments. In that case, the money-lenders get the benefit of the real labor.

If instead the money-lenders decide to deposit the interest-money they earn, and make yet more loans based on it, the amount of money in existence will continue to grow, and the amount of debt will continue to grow exponentially faster.

[Yakk]

Qaanol, yes, the interest is payed out to Bank employees, people the Bank hires to do things (like rent the Bank pays for the building they are in), dividends to Bank shareholders, or to shore up the Bank's balance sheet.

You are also assuming an infinite appetite for debt at the interest rate in question. The demand to borrow money (and actually pay it back!) goes down as you offer more loans -- eventually the bank will run out of people willing to borrow 1000$ and pay back 1100$ (successfully). At that point, trying to lend more money becomes counter-productive for the bank -- the only people who want to borrow money won't pay it back.

Banks are, in a sense, mainly limited by the ability to find people who can borrow 1000$ and pay back 1100$ after a time period. The capital requirements are, in a sense, just a way to make sure that the Bank has "skin in the game" (or rather, that other people have "skin in the game").

The limitation being on people being able to pay back the loans is a good thing, in that the goal is for the bank to search for people able to make economic profits through the use of capital at a rate high enough that it is efficient (as a society) to allocate capital to them. The central bank interest rate throttles what the "acceptable rate" of capital return (including risk) that is "worthy" of societies capital being invested into it. In theory the banks find such people and lend them money.

Housing bubbles (and other asset bubbles) create problems -- if the price of housing is increasing 10% per year, any non-housing investment strategy seemingly needs to beat 10% per year return in order to be "worth" investing money in. This is true even if you can borrow money at 2% or 9% -- so asset bubbles end up placing a floor (higher than the loan rate) on what kind of capital investment you can afford to entertain. So when the central bank goes off and attempts to prime the economic pump by lowering interest rates so low that even a project that returns only 3% on capital is worth investing in (after risk), capital flows get diverted to a spiraling housing bubble where returns are 10%, and neither banks nor lenders are all that interested in the 3% ROI opportunity.

Now, things aren't completely horrible, because the upward spiraling housing prices possibly reflect a desire to own housing. So this encourages housing to be built, and spurs economic activity that way. However, unlike a capital investment in an industrial sense, the return on the housing is merely due to price increases, and not due to productivity increases: if the industrial investment is a term loan, the result of the investment is the productivity. But the bubble investment relies on the "bigger idiot" theory -- the house isn't "worth" the loan terms to the buyer (who is in it to "flip" the house), they are just hoping that it will be "worth" the loan terms to a bigger idiot in the future. And the "worth" of the house (as a replacement for other living methods, say) is heavily dependent on the interest rate. So you get some nasty non-linear interest rate dependencies...

[CorruptUser]

Yakk, you pretty much covered the first half of the video that was linked in the second post in this thread. Another major point covered in that video has to do with fractional lending:

You deposit $1000 into a bank. The bank is allowed to lend up to $900 based on that money.

I take out a loan for $900, and deposit it into a bank. When that happens, no money is taken from your account, nor any other account. My account is simply increased by the amount of the loan.

Now your bank account reads “$1000” and my bank account reads “$900”. There is more money in existence than there was before I took out the loan. The loan created money, to the tune of $900. It also created debt. I will have to pay back interest. Let’s say the interest is as little as $200 over the lifetime of the loan.

The bank I deposited $900 into is allowed to make a loan of up to $810 based on that money.

Someone else comes and takes out a loan for $810, and deposits it into a bank. Now your account reads “$1000”, my account reads “$900”, this other person’s account reads “$810”, and so on with $729, $656.10, $590.49, etc.

The total amount lent, hence the total amount in various people’s accounts, is a geometric series summing to $9000. That means $9000 was created by these loans. You started this by depositing $1000, and now there is $10,000 in existence.

In other words, you deposited $1000, and now the banking system as a whole is collecting interest on $9000 of loans. Also note that your $1000 came into being from a loan at some point as well.

In this example we said the total interest to be paid on $900 was $200, which means the total interest to be paid on $9000 is $2000. This means the total amount that has to be paid back for these loans is $11,000. The process of lending, based on your initial $1000, created $9000 in new money and $11,000 in new debt.

Usually loans are long-term debt, and the interest adds up to about the same amount as the principal. The specific values aren’t important though, what matters is that more debt is created than money.

Since money is created as debt, and more debt is created than money, it is necessarily the case that not enough money exists to pay off all the debts. The only way for the system to remain viable is for the banks to collect their interest payments, then turn around and spend that money again so it can be used to make more loan payments. In that case, the money-lenders get the benefit of the real labor.

If instead the money-lenders decide to deposit the interest-money they earn, and make yet more loans based on it, the amount of money in existence will continue to grow, and the amount of debt will continue to grow exponentially faster.

1) The bank system collects interest on $9000 and pays interest on $10,000. Granted that it still collects vastly more than it pays, but it's not just paying on the $1000 only.

2) The $1000 turning into $10,000 also means the guy that borrowed the initial $900 is making 10 times as much nominally (it does take time for prices to adjust though). It's complicated how inflation works, though the 10x money multiplier is quasi-instant inflation, rather than annual.

3) Bank loans are a major source of money, but not the only source. Governments have the option to issue more of it.

4) People paying back loans (and causing money to 'disappear') is the biggest cause of deflation. Again, governments watch over that and issue more money into existence. The printing of money provides the source of cash to pay back the interest on the loans. So long as the loans result in an increase in actual wealth equal to the increase in cash/debt, printing the money does not lead to inflation.

5) The purpose of having a bank system is to direct capital into investments, which later on yields higher consumption (consumption is the purpose of the economy). The problem we've had recently is that capital was being directed into consumption and being misrepresented as investment. To clarify, a bank loaning a factory money to upgrade the machinery, so as to produce higher quality product, is an investment; a bank loaning money to purchase a bigger house is not an investment, no matter how much your realtor insists it is.

[Yakk]

Actually, a house is an investment -- it produces housing each year, and every year.

The rate at which a house produces housing can be approximated by rental rates.

The housing bubble made people think that housing was an investment whose purpose was to sell the house to a "bigger idiot" next year.

Factories can be much better investments. Factories are investments in the means of production, which both helps produce goods and helps produce employment. Housing is similar to a highly automated investment where very little additional labor (repairs on the house vs someone to supervise the factory) produces the resulting goods.

Of course, a car is similarly a producer of transportation, in comparison to taxi rates and public transport (which is a more labor intensive way to deliver an often inferior product).

However, durable good producers owned by the end-consumers of the produced good in question (cars, houses) should be treated very differently than durable good producers that are owned by employers (factories), or durable good producers that that produce goods that the owner doesn't consume (highly automated factories), because they have very different impact on the economy. Hence a distinction between commercial loans and consumer loans.

[CorruptUser]

A bigger house increases your consumption. It does not produce wealth, it is wealth. If you get more consumption per dollar by buying the house, great, but not if borrow money on the assumption it produces wealth; especially when government policies are distorting the market for you to do so.

"The whole stock of mere dwelling-houses, too, subsisting at anyone time in the country, make a part of this first portion. The stock that is laid out in a house, if it is to be the dwelling-house of the proprietor, ceases from that moment to serve in the function of a capital, or to afford any revenue to its owner. A dwelling-house, as such, contributes nothing to the revenue of its inhabitant; and though it is, no doubt, extremely useful to him, it is as his clothes and household furniture are useful to him, which, however, make a part of his expense, and not of his revenue. If it is to be let to a tenant for rent, as the house itself can produce nothing, the tenant must always pay the rent out of some other revenue, which he derives, either from labour, or stock, or land. Though a house, therefore, may yield a revenue to its proprietor, and thereby serve in the function of a capital to him, it cannot yield any to the public, nor serve in the function of a capital to it, and the revenue of the whole body of the people can never be in the smallest degree increased by it. Clothes and household furniture, in the same manner, sometimes yield a revenue, and thereby serve in the function of a capital to particular persons. In countries where masquerades are common, it is a trade to let out masquerade dresses for a night. Upholsterers frequently let furniture by the month or by the year. Undertakers let the furniture of funerals by the day and by the week. Many people let furnished houses, and get a rent, not only for the use of the house, but for that of the furniture. The revenue, however, which is derived from such things, must always be ultimately drawn from some other source of revenue. Of all parts of the stock, either of an individual or of a society, reserved for immediate consumption, what is laid out in houses is most slowly consumed."

-Adam Smith, the Wealth of Nations. linky, page 234

And anyone saying that bigger houses boost the economy because it means more jobs for construction workers, carpet cleaners, furnishers, etc, is making a broken window argument. By that logic, smashing kneecaps with a baseball bat boosts the economy by keeping doctors and baseball bat manufacturers employed.

[Yakk]

Meh, so Adam Smith makes arbitrary semantic arguments. He is pretty old -- it would be surprising if he got everything right.

[CorruptUser]

Smith's the most important economist, if only because he laid the foundation of the modern schools of Economics. Keynes is second, for noticing that there is a difference in economics between short term and long term. I'd say Hayek is third, but that's more open to discussion.

It's sort of like claiming Newton as the most important mathematician, because he laid the foundations for Euler, Erdos, Hamilton, Gauss, Galton, Green, and so forth..

[Anaximander]

This is all very interesting and I have some more questions:

3) Bank loans are a major source of money, but not the only source. Governments have the option to issue more of it.

4) People paying back loans (and causing money to 'disappear') is the biggest cause of deflation. Again, governments watch over that and issue more money into existence. The printing of money provides the source of cash to pay back the interest on the loans. So long as the loans result in an increase in actual wealth equal to the increase in cash/debt, printing the money does not lead to inflation.

But what happens when:
(1) There is not enough "wealth" that can be created in a meaningful amount of time to back up the "cash" and/or
(2) The means to accumulate cash can not keep up with "debt + interest" owed to maintain an accepted normal (reasonable) standard of living?

Since money is created as debt, and more debt is created than money, it is necessarily the case that not enough money exists to pay off all the debts. The only way for the system to remain viable is for the banks to collect their interest payments, then turn around and spend that money again so it can be used to make more loan payments. In that case, the money-lenders get the benefit of the real labor.

This is what I thought and it just doesn't seem sustainable...or wise...or even ethical. To me, it just sounds like a giant Ponzi scheme that could ultimately result in exponential asset inflation. To wit, as people realize they can obtain wealth without performing labor, the less wealth will be created, the more demand for wealth will increase due to scarcity and the more cash will be needed to obtain it. That is not to say that money-lenders aren't entitled to a paycheck, but they don't "produce" anything yet seem to "own" everything.

I'm not trying to be antagonistic, I just find it genuinely curious (and a little concerning) that this is the way the world works. Everything is financially backed. You can hardly get anything nowadays without a loan. What is backing the financial backers? As far as I can tell, it's just regular old people who get up and go to work to pay their mortgage on time. Should the banks be backed by the government, i.e. "the people", via bailouts if they fail due to excessive risk-taking and to what extent? This all seems somewhat inefficient. Couldn't "the people" just back themselves?

The more I learn about this stuff, the more I question almost everything I've ever learned about economics and systems of governments. It makes me feel like a fool for studying math and physics since those things seem to have marginal application to the "real world".

[CorruptUser]

This is all very interesting and I have some more questions:

3) Bank loans are a major source of money, but not the only source. Governments have the option to issue more of it.

4) People paying back loans (and causing money to 'disappear') is the biggest cause of deflation. Again, governments watch over that and issue more money into existence. The printing of money provides the source of cash to pay back the interest on the loans. So long as the loans result in an increase in actual wealth equal to the increase in cash/debt, printing the money does not lead to inflation.

But what happens when:
(1) There is not enough "wealth" that can be created in a meaningful amount of time to back up the "cash" and/or
(2) The means to accumulate cash can not keep up with "debt + interest" owed to maintain an accepted normal (reasonable) standard of living?

1) Then the loans default and the money 'disappears' that way; specifically, the loans that didn't result in any increase in wealth. Unless the government interferes by bailing out incompetent banks, or distorts the system by adjusting the prices/controls to what it thinks is 'optimal', which caused this depression in the first place. Not that some people in the private sector don't do that too, just that no single person or even a shadowy elite conspiracy has nearly as much power to interfere with the economy as the Federal Reserve...

2) The debt+interest is not a problem so long as the money supply keeps up (governments DO have the power to expand or contract their currencies), and the money supply keeping up is not a problem so long as the actual wealth keeps up, and the wealth will keep up so long as debt+interest is being put towards investments with actual returns.

[Okita]

Just an additional thought for you guys with regards to real estate.

A house's price is not just determined by what is inside it/what it is made from but also what houses in that area are selling for. This is part of the reason a housing bubble occurs because people are willing to buy houses at higher prices in the hopes that they can flip it at an even higher price. This happens to also drive the relative price of houses up.

From a homeowner's point of view, they have increased equity in the house (ie. the house has increased in value). Taking a home equity loan allows you to convert some of that equity into cash. That's not inherently a bad thing when you're using it to invest in something else. However homeowners who spent the investment on their house (new countertops/ remodeled kitchen) didn't necessarily significantly increase the value of the house itself.

The point is that you've got a lot of stated increased "value" that was really only on paper and showed up because everyone agreed "Oh yeah, these houses are worth $400,000 more so you're $400,000 richer". (In my opinion, a lot of economics, finance, and banking comes from shared delusions...kind of like how paper money works) Anyway, banks who acted on that increase in equity can go bankrupt when they have to repossess a house but it turns out the underlying value is a lot less than what it should be to have guaranteed the loan. This is made worse by the fact that the bank used that underlying value to make more loans of their own which becomes less and less supported. Not that people have said that already but I wanted to make the point that a lot of it is tied to how finicky the calculations to determine a house's worth are.

[liveboy21]

Wow, it looks like some interesting points have been raised so far. It seems to answer some questions but at the same time creates room for more questions to be asked. I'll decided to write two topics that could be discussed based on what we've seen in the thread so far.

1)
Ok, so many posts seem to agree that the bank has 'failed' when there is a bank run and that bank runs happen when assets of a bank are lower than its liabilities (or maybe it should be current assets and current liabilities). However, a bank run doesn't necessarily happen on the day that a financial statement is released. This suggests to me that bank runs actually happen when enough members of the public 'think' that the bank is unable to pay off its liabilities.

So, when does the public 'think' that the bank is about to collapse? From the interesting arguements in the above posts, we see that a bank is very unlikely to keep enough cash on hand to pay off all the depositors at any one time. Whether this is a 'good' thing is debatable, but this arises naturally from the ability of banks to give loans and reserve ratio laws.

If I understand this correctly, it seems that the state of the bank before a bank run is almost irrelevant. Once every depositor tried to remove their money at the same time, the bank would fail no matter how liquid the banks assets are (unless they have as much cash as there are deposits and have not made any loans, which doesn't make it much of a bank).

So when does the public decide to have a run on the bank? Is there a certain number that people will not tolerate? Is that number influenced by what is said by influential celebrities and politicians? If a news programme says "the public is rushing to remove their money from the bank" does that cause a bank run?

2)
In the thread so far, there have been a few posts that talk about the role of banks in creating money (multiplier effect) and how that affects our society and our economy. There have also been posts that suggest that the survival of a bank is rather dependent on the state of the economy and a severe change to the economy could put the bank in trouble.

So, how should we look at the decisions made by banks? Are they reacting to the economy in order to survive? Or are they manipulating the economy in order to give themselves a further advantage? Or do both of these apply at the same time?

[Anaximander]

So, how should we look at the decisions made by banks? Are they reacting to the economy in order to survive? Or are they manipulating the economy in order to give themselves a further advantage? Or do both of these apply at the same time?

Given that a bank is a business and businesses exist to make money...and given that most corporations tend to make incredibly short-sighted decisions via rewards based on quarterly or, at best, yearly performance, my vote is both. I would expect most large businesses nowadays would do anything to gain an advantage even if it meant walking off the edge of a cliff. At least you could claim that you've learned to fly for a little while.

[CorruptUser]

I would expect most large businesses nowadays would do anything to gain an advantage even if it meant walking off the edge of a cliff. At least you could claim that you've learned to fly for a little while.

Should I go with Marx's "A capitalist would sell the rope by which he would hang", or Taylor's "Everything is air-droppable at least once"?

Spoiler:

[stevenf]

Please forgive me Liveboy21.

I am entranced beyond words by the notion of a "rouge trader". Perhaps a trader caught with his hand in the client's account...

[CorruptUser]

Rogue Traders are the guys who go beyond their authorization to purchase/sell on behalf of their firms. For example, a trader is allowed to buy up to $50m of stock for a hedge fund, but then violates the rules and purchases $200m worth of stock. The trade is now violating his contract/obligations to the firm. If the stock goes down by just 2% (very likely since large purchases artificially raise the price at which you bought), the firm lost $4M, the managers will be furious at this loss and the trader is likely to face a serious lawsuit from the firm, to say nothing of losing his/her job. So the trader is desperate to make a profit at this point, buying and selling as frantically as possible, for prices relatively far from their actual value, and before the market closes the firm can lose, well, the record is $2.3B in losses.

Rogue Traders are in the stock market. They are NOT part of the normal banking system. Rogue bankers, bankers who issue loans left and right without regard to the actual ability for those loans to be repaid, that's not any individual; the banks themselves did that. The banks had the intention of reselling those debts (given AAA ratings by S&P) to other parties, such as AIG, who ended up with the losses. Whether it was because of banking mismanagement or because of shortsighted government social engineering that this was done is a bit of a debate.