5.9.2011 Ernst Grönblom

Banks – Fundamentally Unstable

Kickbacks in the Financial Industry

Last August, the news covered economic topics daily, mostly in a negative light. Among the covered topics were two important ones that were not given adequate attention. The first one was the Statistic Finland’s report stating that inflation had increased to four percent. If a few short spikes in inflation are ignored, inflation hasn’t been this high since the 90s. The other topic was the IMF president Christine Lagard’s warning regarding the health of European banks and their ability to survive another possible financial crisis.

Why do we think these two topics are especially interesting? The Finnish economy has always been bank focused and Finnish people have always kept a significant portion of their wealth in bank deposits (according to the Bank of Finland, the total household deposits were worth 80 billion euro as of last August, 15,000 per capita. The interest paid on these deposits was a little under 1% on average).

Bank deposits are often considered to be almost risk free. The previous financial crisis, which peaked in 2008 – when the banks of developed countries were on the verge of collapsing – showed that bank deposits are not safe. Unfortunately people’s memories are short.

What kind of an construction is a bank? A bank or a credit institution is a transaction center. Capital is not always optimally distributed regarding time and place: some people have insufficient funds (people buying their first homes) and others have excess funds (a wealthy retired person with low expenses). A bank works as a distribution center, by pooling excess funds and redistributing the funds forward for a fee. A bank matches those with excess funds with those with insufficient funds and at the same time works as a clearing house. Interest is economically seen as a fee paid for the privilege to use borrowed money (somebody else’s money). Basically interest is similar to rent. A bank pays an interest to a depositor and charges an interest from the borrowers. The banks’ business idea is based on the concept of charging borrowers more than paying depositors. The difference is the profit a bank makes.

Banking industry has a fundamental problem, because depositors are allowed to withdraw their money at any point, but the banks borrow the depositors’ money for a long time (years or decades). Therefore, banks never have even a fraction of the funds they have promised to give to depositors if requested. If too many depositors withdraw their money simultaneously a bank will not be able to complete all the withdrawal requests. This is called a bank-run. Bank-run usually leads to bankruptcy. It is important to understand that even financially sound banks can go bankrupt due to a bank-run. Psychology plays a crucial role in the banking industry. Everything is built on trust: if customers believe the bank is safe, they will keep their deposits there. If customers don’t trust the bank and believe it will go under, they will withdraw their money as a precaution. Lack of trust for a bank usually leads to a chain reaction: (1) depositors get nervous; (2) more and more depositors withdraw their money; (3) bank-run fuels itself; (4) the bank goes bankrupt due to the bank-run. Due to the previously mentioned circumstances, banks are always fundamentally unstable and risky, regardless of banks’ efforts to convince people to believe otherwise. This explains why banks try to create an image of wealth and stability (by operating from fancy offices and using symbols representing strength, such as oaks in their logos or advertising campaigns).

If a bank’s bankruptcy represents short-term risk, inflation represents long-term risk for deposits. For example when a return for a bank deposit is calculated, should nominal interest and real interest rates be differentiated. Nominal interest is the interest rate that the customer sees on a paper. The real interest rate takes into account inflation, in other words the decrease in purchasing power (difference between nominal interest rate and inflation). An example makes the concept clearer: let’s assume we have a 100,000 euro bank deposit with a 1% interest rate p.a. Let’s assume that inflation is 4% p.a. In this case the real interest rate paid on the deposit is 1% – 4% = -3%. This means that even though the bank statement says 101,000 a year from now (=100,000 + 1%), measured by purchasing power the account balance is only 97,000 euros (=100,000 – 3%). The money kept in the bank account has lost 3,000 euros of its value in a year measured by purchasing power. Inflations effect to lower money’s purchasing power in the long run is significant: in the above mentioned example (real interest rate 3%), a deposit worth of 100,000 euros would lose half of its value in a little over two decades. The destruction is difficult to notice and due to evolution psychology, human mind doesn’t recognize slow progressing changes well. If a house is on fire, we run to put out the fire immediately, but we let corrosion do its damage for years. People have a tendency to forget or underestimate the effects of inflation, which Lord Keynes called the “money illusion”.

On top of deposits, banks have another way of getting customers’ money to bank’s balance sheets almost without interest. Asset backed investments, such as index notes and principal protected notes are a basically a straight transaction from the customer’s pocket to the bank’s balance sheet. In these investments the customer carries the bank’s risk, unlike the name implies. Additionally these investments don’t offer protection against inflation, meaning that even though the principal is paid back at maturity (if the bank is still operating), inflation has most likely eaten away some of the investment’s real value.

We want to remind that our customers’ funds are always 100% separate from our company’s balance sheet, which means that our customers don’t carry HCP’s risks.

Kickbacks in the Financial Industry
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