The current financial crisis is a serious situation because it affects the foundation of the banking system: trust.
In most cartoons, the image of a bank is that of a safe behind bars, protected by security guards. This concept represents the essence of a bank, a place you trust to keep your money. Trust is so important that in a bank, all decisions are based on the impact that the decisions will have on the bank’s reputation.
Many years ago, banks realized that they could lend money in return for an interest rate.
Imagine a world of one small bank in a small village with total deposits of one dollar. One day, that bank lends that money to one villager. That villager will spend that money at some point. That money will be deposited back in the bank. The money deposited can be lent again. This wheel is the economic engine. The faster and the bigger the wheel, the better the economy.
Banks can multiply the money lent ad infinitum, provided that there are no loan losses or rapid withdrawals of money. In realty, there are loan losses and not all money can be recovered.
Let’s say that there is an economic crisis in the village where people could not pay back their loans anymore. The village bank would be in real trouble because it lent the same deposit to others multiple times. Sounds familiar, there will be a domino effect that could result in a catastrophe.
So there is a regulation that caps the bank lending power, limiting the amount of money that the bank can lend versus the capital in reserve. This is called the capital ratio.
This capital ratio is defined in accordance with the loan losses probability. It is determined by the credit default probability (PD) and the losses given in the event of default (LGD). [That leverage power bank is used it to borrow from other banks].
The probability of default is knowledge that banks accumulate over time. With this knowledge, risk managers analyse risk factors that could contribute to a default (for example, capacity to pay back, stability, employment.)
The main cause of the credit crisis lies in the other part of the equation. The perception of risk of losses in the event of default (LGD) has been removed by guaranty (derivative) from other banks or insurance companies. That is what AIG was doing for mortgages.
Consequently, banks felt compelled to lend almost ad infinitum because their capital ratio requirements was alleviated by the reduction of the LGD to zero. They even overrode basic credit policies.
In a traditional credit crisis, the default is on the borrower side. The problem here is twofold because both borrower and bank are in default. To solve the problem, both aspects must be addressed: 1) the foreclosure must be prevented to stabilise the losses of values. The mortgage must be allowed to be renegotiated by taking into account the capacity of payment and the real estimated value of the house. 2) Trust between banks must be re-established by the government, by insuring banks that they will not fall apart. Those actions will help resolve some aspects of the credit crisis but trust in the banking system will not come back soon. In my view, the greed that stretched the system to the max should be made to pay.