In the past few days, a number of European banks have announced substantial losses on the US subprime and related sectors, which combined with a suspension of redemptions by various funds, caused temporary panic in money markets. Both the European Central Bank and the Fed responded by injecting liquidity into the system, but market confidence had been shaken so badly by then that dislocation in credit and equity markets became unavoidable.

The scale of losses has increased after Thursday’s beating in the stock markets that saw US stocks lose over 3%, followed by similar declines across Asia on Friday. There is a lot of refinancing that will hit the interbank market next week, usual for any mid-month, which given this week’s dislocation points to further volatility. At some point, both the Fed and the ECB will need to intervene directly (moral hazard) to avoid further panic.

Every time markets anywhere tumble, media speculation inevitably focuses on the identity of the biggest losers. In particular, the likelihood of losses being sustained by highly visible, famous or simply obscenely rich people is greeted with more than its due share of glee.

However, this article will not focus on who lost what and when, but rather will focus on the more important question of why.

What banks do

Banking is such a simple business that governments around the world feel the need to erect entry barriers, while bankers themselves adopt unnecessarily arcane jargon to give themselves an air of intellectual superiority to go with their generally good fortunes. After government bureaucrats, bankers command the highest ratio of social respect to intellectual capability. In other words, for a bunch of fairly simple if not dumb people, bankers sure are well-treated by society at large.

The function of a bank is simply to collect savings from individuals, for which it pays a minimal interest rate, called the savings rate, that increases relative to the time that the funds are locked in. The funds thus collected are used by banks to lend money to companies and to purchase securities issued by governments and other borrowers, earning interest on such lending. Banks pocket the difference – or margin, to use the jargon – between the savings and lending rates, from which they deduct staff expenses and losses.

Now, that doesn’t sound too complicated, does it? It’s not, but there are always other factors at work that help to determine exactly how much banks can make. For example, central banks may prevent local banks from lending money abroad or, more pertinently in Asia, foreign banks from lending money locally. In some countries, there are rules about how much banks need to lend to the local government, controls on both savings and lending rates and the like.

The reason for that simplistic explanation of banking given above is not to insult the intelligence of Asia Times Online readers but rather to show how even with simple business models, people can rack up billions in losses in a matter of months. I am always intrigued by the specter of losses running into billions. A simple example would suffice – if one were physically to burn US$100 bills at the rate of one every 10 seconds (six every minute), it would take more than three years to get through a billion dollars – yet banks casually and routinely make such announcements all the time. They either must have some really large furnaces to burn all the money in, or be experts at making investment losses. Of the two, I rather suspect the latter, if only because the former still involves too much physical work that bankers are unlikely ever to pursue in their lives.

New market realities

In the comfortable existence of global bankers, this decade marked a seismic shift for reasons that are entirely outside their sphere of influence. The reference is of course to Asian central banks, which merrily started accumulating American and European bonds at a faster clip than at any other time in history. In so doing, these central banks removed the comfortable spread between borrowing rates and lending rates, because bond yields dramatically declined as a result of their buying.

Thus when central banks around the world tried to fight inflationary pressures by increasing interest rates from 2005 onward, banks found themselves in the unenviable position of having investments that yielded less than what they had to pay on savings accounts. That was the most extreme case, for some European banks, but for most banks the new reality was at least a rapidly declining margin. Because of this decline in margins, banks around the world were forced to increase their own leverage – so instead of borrowing $100 from investors and lending $100 to companies, they now had to lend $200 to make the same amount of money.

This they did by borrowing $100 from other investors, for example Asian central banks, which thought this attractive, as they received higher interest rates from banks than from governments for similar levels of risk. The rapid acceleration of reserve accumulation by Asian central banks this decade increased the pressure on lenders to borrow more money to make the same or higher net profits.

Banking on globalization

As if one external source of change wasn’t enough, there was also a second factor that played an increasingly dominant role over this decade. That was demographics – the aging of populations in both Europe and the United States. While the latter managed to make do with higher immigration that helped to compensate for its population graying away, European countries remained obdurate on immigration.

As populations age, they also tend to save more than they spend. This was another source of excess savings that helped to increase the overall borrowing costs of banks in North America and Europe (remember the minimum savings rates mentioned above), while simultaneously reducing the number of customers willing to borrow (as old people tend not to borrow).

Looking for ways to manage this train wreck, these banks aggressively expanded their loans to exotic customers, the type that would have been denied banking barely a generation ago. For the US banks, the easy choice was to lend more money to immigrants, while for European banks; it was to lend more money to either US banks or to the securitized products marketed by such banks. I wrote in a previous article about Asian central banks suffering collateral damage from all this. [1]

This is globalization, after all. A saver in Sichuan or Salzburg doesn’t lend money in Chengdu or Austria; because of a paucity of local opportunities, it is more than likely that they both lend to a Mexican immigrant in San Jose, California. That is the commercial extension of what I called imperialism [2] in a recent article.

Bailouts and haircuts

It is generally a feature of any market crisis over the past 20 years that a well-known European bank would announce staggering losses, and then be bailed out by its government. True to form, this week we saw announcements from Germany and France about large losses of banks there on the US subprime crisis. Authorities immediately convened rescue groups for stricken banks, helping to avoid any further fallout. For their part, American bankers have been nervous about the fate of a largish investment bank, although any speculation about a failure is being pooh-poohed vehemently.

The process of taking losses on investment losses is euphemistically referred to as “haircuts” by bankers, even if the scale of losses absorbed would argue for more colorful phrases reminiscent of the Queen of Hearts. [3] While not every haircut needs a bailout, someone eventually pays. The most common form of a bailout is a direct rescue that is arranged through the good offices of a state-owned bank.

The more indirect route to a bailout is through interest-rate policies. Former US Federal Reserve chairman Alan Greenspan notoriously invoked the option to cut interest rates on many occasions, helping to thwart banking crises in the US, but creating in its place the asset bubble that now threatens the global financial system. Today’s central bankers appear to be more focused on avoiding inflationary pressures, but they haven’t been severely tested with a crisis yet.

In particular, I find the social aspects of the US subprime crisis a matter of interest. It is not often in a democracy that a large and visible minority suffer the indignity of bankruptcies and losing their homes without repercussions on government. In the current situation, the preponderance of losses among younger families of a minority background mean that the chances of political intervention are simply too high.

In so doing, though, Western governments threaten to unleash another mountain of fiat money on the world, in turn reducing real returns further. While the initial moves such as cutting interest rates or providing credit relief to beleaguered individuals unable to meet their mortgage obligations may help to stem the current crisis, the longer-term impact on government credibility as well as currency values will necessarily be negative.

There is no reason for Asia to participate in this bailout; indeed, it is within its interest to exact the highest possible political costs on the US and Europe when they go about rescuing their banks or individual borrowers. This can be done only by a sensible policy of removing the automatic link between reserve accumulation and current-account surpluses. Asian central banks must reduce their holdings of US dollars and euros now, thereby pushing up borrowing costs for the US and Europe. That increase in borrowing costs will more than offset any central-bank accommodation in those countries, and help Asia to gain the upper hand in negotiations over trade, intellectual property, global warming and other issues.

Detritus, Samson and Delilah

Credit-market losses are like detritus suspended in an aquarium, mildly irritating at first but eventually toxic for all inhabitants in the system. The biblical figure of Samson was felled by Delilah; in much the same way, global banks have to endure “haircuts” on their investment portfolios that eventually will force central banks to cut rates. By blithely accumulating government bonds in the US and Europe, Asian central banks have unwittingly played the role of Delilah.

Rate cuts in the US and Europe would help generate accounting profits for Asian central banks in the near term, but the policy also sows the seeds for future crises in the US and Europe. The only way to break this vicious cycle is for Asian savers to cut their overall allocations to the US and European asset markets, focusing instead on markets around the region. The additional benefit of this approach would be immediate results on difficult negotiations involving protectionism, global warming, and intellectual property.

1. Robbery of the century, Asia Times Online, July 14, 2007.
2. New imperialism, ATol, July 21, 2007.
3. Alice’s Adventures in Wonderland by Lewis Carroll.

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