How Banks Work (and the things they don’t want you to know)

Gordon Kerr 19th Jul 2022 One Comment

Reading Time: 8 minutes

This post is sponsored by Tally

 

When you deposit your money into your bank they keep it safely in a safe somewhere, right?

Wrong.

Actually, when you ‘deposit’ your money with a bank you basically ‘lend’ it to them…at least that’s the way they think of it.

In fact, if everyone tried to get their money out of their bank accounts right now they simply wouldn’t be able to.

Sounds weird? Sounds scary? Yup. There’s something wrong with the banking system and we think you need to know about it. Here’s the real lowdown on how banks work.

• How banks work (or rather how they don’t work)
• The financial crisis is still with us
• Regulation of banks post GFC
• Brief historical overview
• Failed bank accounting
• IFRS Accounting Standards: How to cook the bank books
• Stress tests and other nonsense
• Conclusion: Can you trust the banks?

 

How banks work (or rather how they don’t work!)

When you put your money into the bank you would expect that they kept it nice and safe for you.

Well they don’t.

They lend it out…over and over and over again.

Our high street banks use customer deposits as leverage to write new loans. And these customer deposits only represent a tiny fraction of the money being lent out, which explains why the system is called Fractional Reserve Banking (FRB).

With FRB, a depositor of say £100 does not have a dedicated space in the bank vault with their money sitting in a tray.

Rather, the bank uses the £100 deposited to make a loan to the next customer applying for, say, a car loan or mortgage.

The depositor (AKA you, giving them your hard-earned) is in fact a lender.

This recycling of deposits is so intense that at the time of its catastrophic failure during the Global Financial Crash (GFC) of 2008, each pound deposited in Royal Bank of Scotland (RBS) had been lent out 67 times!

 

The financial crisis is still with us

To understand how banks work you have to go back to the Autumn of 2008 when there was a collapse of the entire Western banking system.

Because banks were so interdependent, when Lehman Brothers collapsed it created a domino effect that seized up the global banking system, a bit like a racing car whizzing around the track at 200mph running out of oil.

 

The 2008 financial crash – exposed the banking system

The main reason that the Western banking system failed in 2008 was too many banks making high risk loans.

To drive growth, all banks reduced BOTH their lending quality standards AND their margins.

Put simply, they were taking greater risk for lower returns.

This was only ever going to end badly, particularly as regulators were asleep at the wheel, (as they still are today).

The USA’s ‘sub-prime’ mortgages were heavily blamed, which is understandable given that US banks had been lending money to people who, in normal times, would fail credit checks. The question is why?

The answer is simple. US banks convinced themselves that house prices would always go up by a minimum of 6%, which was conveniently also the interest being charged on sub-prime mortgages. So, they handed out mortgage loans to more or less anyone, irrespective of their credit score.

This ended in not only tears, but in a global financial crisis thanks to the highly leveraged nature of FRB: when interbank credit seized up and at the wholesale level central banks were unable to support their nation’s own banks.

You’d think that the banks would have learnt from their catastrophic mistakes.

But no. Lending is even greater now thanks in most part to money being the cheapest it has ever been and central bank support of banks via money printing operating on speed.

 

Regulation of banks post GFC

After a financial crash that closed businesses, created mass panic and brought poverty to millions, you’d think that the banking system would have been cleaned up. Hmm. No, that’s not how banks work!

Radical reform or business as usual?

As the clamour grew for radical reform in the wake of the crisis, the spin machine of the banking lobby kicked into action.

Bankers claimed that not much was wrong. Rather, they implied that like Halley’s Comet, financial crises “just happen” every few decades. And if people wanted banks to support economic growth by providing loans, we’d just have to put up with it.

Against this, a tiny minority of banking experts strove to explain that our present banking system was then, and remains today, bumbling along the bottom.

Astounding levels of leverage

Any company leveraged at a ratio of 97:3 (the official global level of permitted bank leverage then and now) is fragile to say the least. How can anyone feel safe know that the institution they trust their money with has borrowed 97% of its money?

And when you consider that it’s not uncommon for banks to report losses of up to 3% in a financial year, banks can be, more or less, bankrupt.

But politicians don’t want the root and branch reform that is genuinely needed in banking.

Instead, the GFC was presented as a temporary liquidity crisis, a bit of a blip, which was easily dealt with, through lending and, since 2009, printing more money or “quantitative easing”.

 

Failed bank accounting

It seems reasonable that quarterly and annual accounts providing an accurate picture of the health of our banks should be the bedrock of the Bank of England’s supervisory activities.

Afterall, shareholders and lenders in the capital markets rely on the accuracy of those accounts. Accounts that must protect those exposed to bank credit risk, and taxpayers in the case of bailouts.

However, not everyone benefits from accurate accounts. Shareholders planning to sell their shares benefit from overstated profits.  And senior bank executives, whose performances are typically measured and rewarded on the basis of profits, also benefit from profit exaggerations.

Banking is a highly complex and interconnected business, and failures in accounting are especially problematic for banks.

 

IFRS Accounting Standards: How to cook the bank books

How banks look profitable while teetering on bankruptcy

There are a number of problems with IFRS accounting standards which continue to apply to banks.

I have set out a short list.

Some of the terms may be unfamiliar to ordinary bank customers.  Some may not be well understood by bank regulators.  There is insufficient space here to explain each of these facets of banking, but rest assured each point is a major contributor to inflated and exaggerated bank profits and solvency:

• Profits can be recognised from the increased value of assets, or decreased value of liabilities, on the basis of a claimed ‘market’ price, even though the assets (liabilities) could not be disposed (redeemed) at that price.
• Profits can be recognised from asset / liability revaluation as above but not on the basis of a claimed ‘market’ price but based on a financial model – a spreadsheet – built by the bank’s employees.
• The value today of uncertain future cashflows can be recognised as profits even when using implausibly optimistic forecasts.
• Banks no longer need to make provision for losses which they genuinely expect to incur from doubtful loans.

All this means that a bank can be completely unprofitable in a real sense but still look on paper as if it is making a huge profit!

Much activity in our banks is targeted at nothing more than exploiting these accounting rules to record fake and inflated profits.

 

Stress tests and other nonsense

The difficulty for politicians and regulators that were happy to go along with the  lobbyists and present cosmetic tweaks to bank rules was that our banks kept recording substantial losses, making it obvious to all that they were existing on life support.

Unsurprisingly, the Bank of England changed tack in 2014 jumping on the stress test bandwagon.

Given the sheer size and opacity of published accounts, stakeholders in banks have been  encouraged to trust the Bank of England’s exposure forecast which considers the capital and reserves of each bank, and how each bank will survive a series of economic shocks in imaginary scenarios playing out over a five-year periods.

But of course, these stress tests are just giving us false hope.

Since the start of this exercise Professor Kevin Dowd of Cobden Partners and Durham University has elegantly debunked each annual stress testing exercise.  Here is his 2019 report.

Professor Dowd argues that the UK’s banking system is still an accident waiting to happen. The continuing weakness of UK banks after a long economic recovery is testimony to the failure of the Bank of England to perform its core function and rebuild the strength of the banking system after the trauma of the crisis.

 

Can you trust any bank? No

A clever trick of Western central banks since the GFC has been to join forces in asserting the value of global rules.

It’s worth noting that the Bank of England’s former Governor, Mark Carney, chaired the global rule making body (the Financial Stability Board) from 2011 to 2018.

And now, when stuck in a tight spot, during a Parliamentary Select Committee grilling, our present Governor – Andrew Bailey – simply refers to ‘global rules’ in the same way our politicians, pre-Brexit, referred to EU law.

What he’s really saying is that there is nothing we can do about it.

Banks remain in as weak condition today as they were in 2007.  Nothing material has been reformed or fixed. We just don’t notice it because quantitative easing (money printing) has masked the problem. In other words, if quantitative easing had been around in 2005, there would never have been a visible banking crash. Visible being the key word!

These days, bank depositors feel secure because of the £85k Financial Services Compensation Scheme whereby in the event of a bank failure the first £85,000 that you deposit in any one banking institution will be reimbursed by the Government.

But this continuing grinding banking failure is not victimless – the victims are ordinary people suffering from near zero interest rates and the consequences of that. Interest rates have been at near zero for years and the author expects them to stay there.

The result is the next generation abandoning any hope of ever owning a house because the cost of buying is simply too high.

Banks must be reformed.  Unless they are, commodities seem the only haven for wealth preservation, with investment and a gold-backed form of money increasingly likely to outcompete fiat.

 

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