Banking for Smart People who aren't Bankers

Those "For Dummies" books and "Complete Idiots Guides" always rubbed me the wrong way. Who buys this stuff? "Hey, I'm a complete idiot, that's for me!" Uh-uh. You're smart and so am I. So let's talk about banking. I'd like you to understand, in simple terms, what's going on when they build a pyre of French antique commodes where Nassau runs into Broad at the corner of Wall Street and start burning bankers alive.

For the show trials they are a'comin. There is a lot of outrage that Uncle Sugar has provided bank capital and weeks later those damned banks are still not lending it. Well, let's examine that.

Basic banking is just a little more complicated than regular industrial enterprises. In a regular industrial enterprise the raw material is, say, habanero peppers and the end product after some processing is hot sauce. For a basic bank, the raw material is money and the end product, after no real processing, is also money.

So an investor -- you remember investors, right? they used to have money to invest -- an investor or investor group gets a bank charter, puts capital in to capitalize their bank, and opens for business. The bank charter allows the bank to take deposits and make loans. The bank loans its deposits. It does not loan its capital. Its capital sits in the vault.

That sets up popular misconception number 1: that having new capital from Uncle Sugar, banks should be lending it. No they shouldn't.

Banking regulations permit banks to lend out up to twelve times their capital.

What about deposits? Simple, plain vanilla banking is taking in deposits, and making loans. The bank pays as little interest as it can on deposits, and charges as much interest as it can on loans (plus points, fees, service charges, and whatever else it can get away with). The difference between interest and fees charged on loans and interest paid on deposits is profit.

The limit on the bank's lending is capital, not loans. If the bank wants to grow, that is to lend more, it needs more capital. A bank that lends less than its capital would permit is considered a conservative bank -- it has a capital surplus backstopping and its lending activities.

As for loans and deposits, the bank can lend out less than it takes in, the same amount as it takes in, or more than it takes in. If it lends out less to regular borrowers than it takes in from depositors, that excess doesn't sit in the vault. The bank buys bonds -- corporate bonds, government bonds, mortgage bonds, whatever. (A bond is just a loan in the form of a security.) If the bank wants to lend out more than it actually has from depositors, it can bid for deposits by raising the interest it pays, it may be able to borrow from the Federal Reserve, or it can borrow from other banks in a huge inter-bank market. Have you been hearing anxious talk about LIBOR, and not knowing what that is? LIBOR is the London Inter-Bank Offer Rate, a rate at which banks commonly lend to each other on a short-term basis.

Banking is a great business . . . you make a margin between what you give and what you receive. It is not a large margin as a percent of the loans and deposits, but because those are a multiple of capital, the returns on capital are large. Or they should be. But then there are losses.

Losses. Ugh. Banks expect that a small percentage of the loans they make to go bad. Some borrowers just get in trouble, some are crooks who never intended to pay back. In that case the bank forecloses on the house or repos the car, and takes what it can recover.

What the bank never expected was that so many of the mortgage bonds would go bad. Those bonds were supposed to be safe. Isn't that why Moody's and S&P put their great triple-A ratings on them?

So the bank looks at its loans and its bonds, and instead of a profitable portfolio it has bad loans, loans in collection, real estate on its own books losing value while no one maintains it and lawyers fight over it, and triple-A rated mortgage bonds in default. These losses are reported on the Profit and Loss Statement, and also charged against capital on the Balance Sheet.

Capital. You remember capital. Capital limits the loans that the bank can make. If the bank loses capital, it loses lending capacity. It can lend less to borrowers. Loan limits get cut. Lines get called, or not renewed.

When you multiply this effect by ten thousand banks across the national economy, you get a liquidity crunch and the economy judders to crawl almost immediately. You probably remember when it happened this time around: it was right around the day when Lehman Brothers went belly-up and we all realized how bad things were. We held our wallets closer, and stopped opening them for discretionary purchases. The economic motor slowed as if its power cord were yanked from the wall socket.

Banks can lend less, but with individuals and businesses cleaving tightly to their wallets, borrowers want to borrow even less. This answers popular misconception number 2: with new capital from Uncle Sugar, banks' capital is not constraining lending and liquidity should immediately re-form in loan markets. No it shouldn't. At this point the problem is not so much supply of loans. It is demand for loans.

With the economy slow and uncertain, everyone pulls back. If unemployment is rising, jobs are scarce, pay raises are hard to come by (and bonuses are made illegal by Acts of Congress), it is absolutely rational behavior for consumers to cut back on their use of credit. If business opportunities are thin on the ground and companies lack confidence, it is absolutely rational for business owners to hunker down, defer capital projects and try to cut back their demand for working capital.

There are some complications that I haven't got into here. I have tipped my hat to the ratings agencies, who have screwed up big time. I believe the standards-setting organizations for accounting and auditing have made this situation worse than it it needs to be by forcing banks to recognize losses too early on loans that can be worked out, crushing their capital. I have not talked about the Federal Reserve, the operations of which influence the price and availability of money.

What is the cure? I just alluded to part of the cure, it is that which cures all ills -- time. Given time, banks can work out of losses on many bad assets. Given time, individuals and business owners will regain confidence and begin to demand loans again.

Next, price. The Federal Reserve has hooked up the economy the a veritable firehose of liquidity and reduced the price to about zero. That lets banks cut their lending rates to levels that bring back prospective borrowers and yet still allows them to make a great margin.

Also, money. Banks are being recapitalized as the leaders of the industry and government figure out how to deal with the upsurge in bad loans. It is not only government money coming in to recapitalize banks, but also private capital that banks call upon from those that still have it. This also takes time (see above).

Hang in there. It gets better.