It seems appropriate to share this entry on money that I posted to the glossary yesterday in light of the Silicon Valley Bank failure.
SVB would have survived if they had realised that all money is debt.
They failed to match their current and longer-term cash liabilities.
They did not realise that this double entry was really their job.
As a result there is a cost to society.
Understanding money matters.
All money represents a promise to pay denominated in the fiat currency of a particular jurisdiction. The UK pound sterling is a fiat currency, as is the US dollar, the euro, the Japanese yen, and all other major currencies in the world.
Fiat money is created by the acknowledgement of a debt and is destroyed by the settlement or cancellation of that liability (see money creation).
In a fiat currency system, there is no asset backing for the money that a jurisdiction creates. This has been true in almost all jurisdictions, and all major ones, since the final abandonment of the gold standard by the USA in August 1971.
It is commonplace for people to think that money has a tangible existence, mostly because of the existence of notes and coins. This is not true. Notes and coins are simply tangible and transferable representations of the government's promise to pay which it redeems by accepting them in payment of tax.
As a result, the idea that there is ‘money in the bank', as many people commonly state, is not true. No one has ‘money in the bank'. The only thing that a bank has is a general ledger (see double entry book-keeping) that records the money owed to it and the people to whom it owes money.
Banks are as a result just giant exercises in book-keeping, whatever mystique they like to create around the process.
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“Money is just double-entry bookkeeping”.
Thanks for putting that statement as the headline; because I believe that is the essence. It could be a tally-stick, a shell, a coin, a piece of paper; but it ‘stands for’ a double-entry bookkeeping process. There is a qualification; there is a hierarchy of money that you only notice ‘in extremis’, when you discover who is the lender and dealer of ‘last resort’; virtually invariably that is the sovereign issuer of the polity’s currency. Now can you tell the neoliberal and neoclassical economists?
So let me get this right – see example below.
I want to use this to clarify and remove the misunderstanding between friends/family.
Pls correct if required.
A) When monthly salary is automatically transferred into an employees bank account, it actually means that the bank owes that amount to the employee (the amount represents a liability). So this is a debt. The amount that appears in the employees online/paper statements is a record of the amount given/loaned to the bank by the employee (through the employer’s payroll) and the date it was created. Of course, if the employee withdraws/spends the amount, the debt is cancelled. If the amount is not withdwan/used by the employee, it just continues to be recorded as a liability by the bank.
B) The bank can also use the same amount and simply issue it as a loan to an individual/corporate. The amount used by the bank is then recorded in the borrower’s account as a loan (and the amount can be used by the borrower for spending/buying etc etc). This loan needs to be repaid by the borrower over a specified period plus interest. When the borrower repays/settles the loan or if it is cancelled/waived etc the debt is cancelled and destroyed.
C) When the employee needs the bank to repay the salary amount, the problem arises due to the bank having used the slalary amount as a loan to a borrower. The bank is not immediately able to meet/settle its liability because the borrower has not yet repaid the amount back to the bank.
A) Correct, but remember the debt from the bank replaced a debt from the employer for pay
B) I do ot follow your ‘same amount’. All debts are distinct and separate so I think this wrong but as I do not follow the example precisely, and some of it is right, am not sure what you asking
c) I am not sure what you are asking. Why does the employee need the bank to repay the salary amount? Who to? And the bank never loans one persons money to another person. I think you believe banks lend other people’s money. They don’t. Money is created by lending – see money creation in the glossary.
The secret to all good comedy….. and banking…. is timing.
No bank ever matches the maturity of its assets (loans made) and liabilities (deposits taken in). Who would want to lock their money up with a bank for years without access to it? Who would want to borrow to buy a house on overdraft that the bank could call in tomorrow? “Maturity transformation” is one of the central purposes of banking and is essential in any economy.
They also take credit risk. Will the company they lend to be able to repay the loan?
The problem is that these activities are (a) profitable – so banks want to do as much as they can and (b) dangerous – so regulators want to put strict limits on it… but limits that are consistent with allowing banks to deliver credit to the real economy.
The regulations are (necessarily) complicated but are designed to allow banks to take unexpected hits to their loan book and meet all reasonably expected demands to withdraw deposits…. but still “do their job” of lending to business. It is a constant balancing act.
Even if you get the correct balance in regulation there are then issues of compliance. There’s no point in making good law if it is ignored.
With SVB it is the old story (and it is always the same story) – (1) “something” triggers a few people to want their money back (2) Other people spot this and join the rush…. (Think Mary Poppins and Fidelity Fiduciary Bank) (3) Bank finds it can’t liquidate its assets quickly enough or at a sufficiently good price to meet all the depositors demands (4) It goes bust.
Now, have argued here that changes to banking regulation made in response to the 2008 crisis had made the Banking System a much safer place… a system where a USD200bn (by asset size) could not go bust without malfeasance
What was the “something”??
When I heard it was in trouble I lazily assumed it was due to too many bad loans made to tech companies. In reality it appears to have been interest rate risk (large falls in the value of its US Treasury bond portfolio) rather than credit risk that brought the bank down…. although it is hard to imagine that its loan book is looking too clever given the collapse in Tech Company values in 2022.
Who knows how rumours start… but start they did and depositors withdrew their cash (whether it is “money out the bank” or “toilet rolls from Tesco” if you are going to panic then panic early… while stocks last!!). SVB found that when they sold their portfolio of highly liquid US Treasury bonds (held for this very purpose) the prices were far below the price they bought them for (cf. the crisis for pension funds in the UK gilt market) and it then got ugly quickly.
So, the key questions I have are (a) Were the rules good enough?; (b) were they followed?; and (c) What about the UK?
The first thing to say is that the rules were relaxed in 2018 in the US for “small” banks. Frankly, this is appalling – how does one consider a $200bn bank “small” and are our memories really that short? The US Banking Lobby is very powerful and the Trump administration did their bidding.
Second, SVB almost doubled it asset size in 2022 – you don’t do this without offering “something that is too good to be true”. This was a Red Flag. It also had no Chief Risk Officer for the bulk of 2022 – another Red Flag. It seems likely that with this management approach then rules (even less stringent rules applying to “small” banks”) were not followed. In any case this is a massive failure of interest rate risk management…. one I can scarcely believe could happen in this day and age. Management and Regulators need to be held to account.
Third, the UK arm of SVB has been bailed out by HSBC. This means that we will never know what failings there were (if any) by the BoE of SVBs UK managers. But what is the quid pro quo for HSBC taking over? Also, were the rules relating to segregating/ring fencing UK institutions (a) sufficient and (b) followed.
I would also add that, at this point, things are holding up. The system has not fallen down and the taxpayer is not on the hook…. although the provision of liquidity by the Fed looks a bit like a bailout. Having said that, this might lead to a halt in rate rises so every cloud has a silver lining!
Thanks for that
I think the key to the tun is the like fo diversity in the customer base
That made it a small bank and so lightly regulated. It also escalated the risk, considerably
Deposit base concentration/correlation is an interesting issue. Concentration and correlation risk on the credit side is well understood and regulated… but I am not sure that there is a similar concept in deposits.
LCR rules require a bank to operate for 30 days without access to interbank borrowing. However, it is NOT assumed that all depositors will take their money out at the earliest available opportunity. They rank the “quality” of deposits according to a presumed “flight risk”. Eg. deposits from other banks are presumed to be withdrawn at the drop of a hat; FDIC insured deposits not at all. In between these extremes there are various other categories. Whilst there are rules prevent you getting all your money from one place I am unaware of rules that look specifically at correlation of depositor behaviour.
Should there be? I am not sure. “In a crisis correlation = 1” is well known and the current LCR rules should cater for this. In the case of SVB I wonder whether it was required to comply with LCR rules and, if so, did it actually comply.
In any case, it is a mess.
PS For some reason I posted my previous piece here rather than in you blog specifically about SVB. Sorry.
Clive,
Seems the Fed agrees with you. No more rate increses on the horizon,
https://www.reuters.com/markets/us/goldman-analysts-no-longer-expect-fed-rate-hike-march-after-svb-failure-2023-03-13/?utm_source=Sailthru&utm_medium=Newsletter&utm_campaign=Daily-Briefing&utm_term=031323
Apologies Goldman Sachs agrees with you.
“In any case this is a massive failure of interest rate risk management…. one I can scarcely believe could happen in this day and age”.
Yeah, yeah, yeah; how often have I heard that? Oh, yes only a couple of months ago after the LDI pensions crisis; and the 2007-8 crash. Never again, never again. Until again happens again.
“Management and Regulators need to be held to account”.
Yeah, yeah, yeah; how often have I heard that? Oh, yes only a couple of months ago after the LDI pensions crisis; and the 2007-8 crash. Never again, never again. Until again happens again.
There is something badly wrong with this whole approach to fixing the problem; and in the digital AI, quantum age we frankly cannot afford the risks we are running. Oh, and little crashes often precede bigger problems to come.
VERY FAIR POINT. As Paul Volcker observed 15 years ago there has been no useful innovation in banking since the ATM…. and I suspect he was right.
However, much as I would wish for simpler times (don’t get me reminiscing about Government bond Trading in the 1980s!) we are where we are and there are two ways to proceed;
(1) Force a massive simplification by (say) banning almost all derivatives… which would be a huge challenge at a practical and political level.
(2) Allow complexity but ensure that banks are sufficiently liquid for nearly all situations (for ALL would be impossible) and sufficiently well capitalised so that in the event of failures it is not a cost to the public purse.
Currently we are trying (2) (although (1) would still require (2)…except it would be easier to monitor).
The current regime tries to minimise the risk of failure but acknowledges it will still happen occasionally…. and when it does it hopes to prevent contagion and cost to the government.
The REAL test for SVB is to see who what the losses actually are, who bears them and what the fall out in the real economy is. If small depositors are made whole, large depositors take only a modest haircut and the Government does not bail out then one could argue that this is a “lose” for micro-regulation but a “win” for the broader regulatory environment.
We will see….
On an even broader view I would paraphrase your question “why do banks keep making the same mistakes?” and the answer is “there are only two mistakes you can make; lend to people that don’t pay back and failing to keep enough cash in the till. All banking failures of the last 4,000 years are variations on these simple themes”. There were banking crises aplenty a century or so ago in much simpler times so I am not sure we should allow complexity to mask the fundamental trade off that we as a society make….. the “good” we get from banks versus the risk we run when they get it wrong.
Thanks, Clive. You are right to point out that maturity transformation is one of the points of banks. They survive on confidence, and die when confidence disappears.
As I understand it, the assets held by Lehman Brothers were ultimately worth more than its liabilities, but it didn’t have enough liquidity when needed. (I may have this wrong, but I think the same applied to Northern Rock.) Given enough time, it may well turn out that SVB is not balance sheet insolvent.
It is cash flow insolvent
Given time it may not be, as you say, balance sheet insolvent
Cash is king. Cashflow decides everything in a crisis. The problem is dormant cash doesn’t earn money, and banks ern money out of money by turning it into credit. A crisis is always decided by who needs cash most, and has least access to it. The blance sheet shows working money; it isn’t usable in the crisis. It is irrelevant if it isn’t cashable. This is the fundamental nature of the money system; there is no way round it, that I have ever seen or am ever likely to see.
I remember Lehman Bros. The “Recovery Rate” on which Credit derivatives settled was 8.5 cents on the dollar. Ie. this was the market clearing price of Lehman’s debt shortly after the crash. The “work out” is still ongoing and I believe stands at about 57 cents on the dollar…. with lawyers fees approaching USD 8bn !! (But don’t take this as Gospel).
The world is full of ex-traders that say “if only I could have hung on a bit longer” or “It was fundamentally the right trade”…. but the key here is that they are “EX”. All banking and trading is conducted on borrowed money (margin)…. and when the margin call comes and you can’t pay it’s curtains. Whether you are RBS, Lehman or Clive Parry you must be able to meet your margin call! The problem is that the “big guys” think margin is only for the “little guys”. Hubris is the killer.
Fair enough.
I must have been thinking of the UK Lehman subsidiary, which paid out all creditors (secured and unsecured) in full, with a substantial surplus. https://www.theguardian.com/business/2014/mar/05/lehman-brothers-administrators-surplus-creditors-paid
I think the US parent has paid out all customers and secured creditors in full, but unsecured creditors only got 40-something cents on the dollar so far.
https://money.usnews.com/investing/news/articles/2022-09-28/after-14-years-lehman-brothers-brokerage-ends-liquidation
May I add that ‘Chris’ on the SVB thread draws attention to the Michael Hudson artile on this. Hudson refers to interest rates in an interesting way, because I think Richard raised the same point a few days ago (I may have mis-remembered), making this observation: “….. interest rates, which spiked last Thursday and Friday to close at 4.60 percent for the U.S. Treasury’s two-year bonds. Bank depositors meanwhile were still being paid only 0.2 percent on their deposits. That has led to a steady withdrawal of funds from banks – and a corresponding decline in commercial bank balances with the Federal Reserve”.
This may or may not be a critical feature of the problem, but it is typical of the crudity of commercial banking; how far can we raise interest rates for borrowers, and how far and how long can we hold off paying depositors anything for depositing, and get away with it? This from bankers who have long defended Samuelson’s account of fractional reserve banking. I think small depositors, reluctant to trust the financial sector (why should they), relying on the government deposit guarantee as their ‘gold standard’, are entitled to believe they are being ripped off.
In the US, remember, Main Street mortgagees after the financial crash were ripped-off by Wall Street; they didn’t readily forgive the Democrats (read Neil Barofsky, ‘Bailout’), and I suspect it drove a large number of Main Street Americans into the hands of Trump.
The Hudson observation seems to relate to Clive’s point about LCR rules:
“LCR rules require a bank to operate for 30 days without access to interbank borrowing. However, it is NOT assumed that all depositors will take their money out at the earliest available opportunity. They rank the “quality” of deposits according to a presumed “flight risk”. Eg. deposits from other banks are presumed to be withdrawn at the drop of a hat; FDIC insured deposits not at all. In between these extremes there are various other categories. Whilst there are rules prevent you getting all your money from one place I am unaware of rules that look specifically at correlation of depositor behaviour.”
The problem seems to be that we never seems to see the next problem, because we think it isn’t really a problem. Again and again. It happens too often; far too often.
Surely liquidity coverage ratios are fairly basic regulatory boilerplate? It was covered by Basel (EU 2015?).
If we can’t even see looming crises with something as low-grade as depositors removing their cash from banks, I am at something of a loss. Surely there should be ‘early warning’ sensors in the system (remembering we live in a digital age)? Or is this another British problem of having the regulations, but withholding the resources for someone actually to monitor the activity?
Have the central banks not a role in this affair? Keeping interest rates too low for too long, thinking this will stimulate useful economic activity, but not looking at what was happening to the easy money. Then raising interest rates, which was fine as long as it only hurt the poorest. But starting to worry when they give a text book example of Warren Buffet’s dictum – “Only When the Tide Goes Out, You Find Out Who is Swimming Naked “. Richard has already argued against their interest rate policy, but will they take heed when it starts to affect the whole edifice?
I will have a major report on QE out after this week
This morning I received a more detailed explanation from Ellen Brown outlining the difficulties which the US banking system is facing and I include the link here.
https://scheerpost.com/2023/03/12/ellen-brown-the-looming-quadrillion-dollar-derivatives-tsunami/?utm_source=substack&utm_medium=email
She is good
Brown points to two possible developments for the US; the public banking movement, and a national investment bank. Unfortunately they look too little and too late, at least to forestall any shadow banking nightmare waiting in the wings.
Both should be developed more quickly here. I remember when the great TSB, and all the Mutuals (in Pensions and Insurance – rock solid and dependable, year in, year out; run by actuaries), were privatised (1990s) by the greediest collection of odious, grasping depositors ever assembled in human history; to feed on the corpse of mutuality that they hadn’t deserved to invest in.
Mutualised High Street Banks; there’s a thought.
It would be good
I’ve looked at this and even though I’m no expert I can’t believe that a bank was set up like this?
Because the crash of 2008 was so huge they think sums like $200 billion are trifling?
What planet were they on? And what does it say about us that we could take such a view? It proves once again that society can get used to anything – no matter how bad.
Our ultimate demise as a species lies in this trait I think!
All of this is the result of optimism isn’t it? And yet time and time again we are told that those who want a world where this does not happen and is much fairer are the dreamers?!
I have in the past written posts that in their last year at school students should learn the craic about money, debts, mortgages and investing, Richard decided for whatever reason to not to approve. Otherwise a lot of parasites would be needing to look for a cardboard box to sleep in.
There used to be a column in the weekend FT written by a man called – Kevin Goldstein-Jackson. He was told at 15 that he was a ‘no-hoper/factory fodder material – he ended up setting up and selling Westward TV.
As a young man he set up an bank account which he called his ‘get stuffed’ account. which meant he could always leave whatever job he was in because he had this ‘fall-back’ bank account to rely on. I had a similar account which I called by what I can assume would be an unacceptable name to the wallflower English – it meant I was a truly ‘freeman’.
No one is teaching young people the truth about life in a capitalistic ‘society’, which of course means they easily become ‘debt slaves’ – mortgage debt/credit card debt/consumer junkies, buying crap they don’t need but only ‘think’ they need.
Fractional banking is indeed a major part of the problem. In the UK in 2008 Gordon Gekko ostensibly bailed out the banks – in reality he bailed out the rich. Had he let the banks go bust it was the rich who would have been broken with ordinary punters covered by the BoE. There would have been a short term hit for pensions which would have recovered quite quickly (pensions are long term investments).
Zero or virtually zero % rates could only mean one thing – a massive boost in asset class investment values, especially property values. Just look at the price of all property,residential and commercial in the UK and elsewhere today – completely and utterly insane. Simply put the markets are not allowed to reset these values.
Eventually they will reset themselves and the longer this is delayed the harder this reset will be. There is a factor that like a huge elephant in the room that no one wants to recognise exists – rational values in property and company valuations – it is going to happen just like night follows day. Fiat currencies are just ‘pieces of paper’ and nothing more – the Weimar Republic should be a reminder and wake up call for everyone – what was it Jackson Brown wrote – fast asleep at the traffic lights.
There is no such thing as fractional reserve banking
If that is what you are saying no wonder I did not approve, nit that I recall it