A Closer Look At Bank Bail-Ins And The Black Hole Of Our System

The bank bail-in rumble is growing louder. After the events in Cyprus, a small country and potentially meaningless in the eyes of most people, it seems that bail-in idea has spread like a virus across the Western world.

Only in the last week, we saw the following developments:

  • Slovenian parliament has approved bank bail-in rules. (source)
  • The leader of the Eurogroup Working Group (Thomas Wieser) revealed that the eurozone should introduce bank bail-in rules from 2016, as reported by the German Der Spiegel. (source)
  • UK based Co-operative Bank announced a bondholder bail-in rescue plan. (source)

All these events come right after the IMF super tax proposal of 10% on savings accounts of households with a positive net worth in Europe (reported on this site) earlier this month.

One could rightfully ask the question why this type of measures are considered in a world which is being flooded with liquidity on a scale that mankind has never seen before (whether one calls it money printing, quantitative easing, easy money, or helicopter money).

The fact of the matter is that, even with excess liquidity, bank losses are still there, as evidenced in Europe (see Europe prepares to come clean on hidden bank losses by Reuters). Europeans are not not privileged on this matter. Recently, the Bank of International Settlements (say, the mother of all central banks) released a report in which they wrote the following:

Only 30% of the large, international banks analysed is more easily able to fulfil a risk-based Tier 1 capital ratio of 8.5% (including the capital conservation buffer) than a 3% leverage ratio, which is the ratio the Basel Committee favours.

This does not sound very encouraging, does it? Nor is the following comment from England’s central bank chairman providing inspiration: “Systemic resilience depends on being able to resolve failing banks in a way that does not threaten the entire system. Fairness demands the end of a system that privatises gains but socialises losses.” Mr. Carney told this during a speech about a week ago.

Admittedely, Mr. Draghi has asked to delay the bank bail-in plans till the Europe-wide banking union is in place. But still, there are more than enough signs of a growing adoption of bank bail-ins.

In order to get a better understanding on how it is possible that the banking system has a real need for bail-ins while having absorbed unprecedented liquidity from central banks, our staff reached out to Darryl Schoon, student of the Great Depression and author of Times of the Vulture. In his book, he correctly predicted the housing crisis back in 2007.

Darryl Schoon took us to the heart of our monetary system. He explained how debt-based banking is the foundation of modern economies , a foundation that is inherently unstable and when stressed, it collapses. Banking is the cause of our problems, not the symptom. The causes of the banking crisis are systemic.

While banks have paid-in capital, that capital has nothing to do with the business of borrowing and loaning, i.e. the credit business. Where does the money come from that a bank loans? It does not come from the paid-in capital, as the paid-in capital sits on a separate deposit in the books. Rather, the money comes out of thin air; it is nothing more than an electronic entry in a computer system. It has a relationship with demand deposits (money deposited on a bank account by a bank client), but the relationship is very low (in the order of 10 or 15 to 1).

Basically, the mechanics of banking work as follows:

  1. take deposits
  2. pay deposit holders the lowest nominal interest rate
  3. use a leverage of 10 or 15 on the deposit base then loaning the aggregate leveraged sum at much higher interest rates.

The money loaned is not the depositor’s money; it is the total deposit base levered 10 to fifteen times the original amount. That amount is issued as credit in the form of loans. The bank is thus creating debt by offering credit. Because of the leverage, it has 10 to 15 times as much loans as it has on deposit.

A bank can borrow money overnight in the repurchase market (repo market) from other banks, in case it needs to meet an obligation which it cannot with its own means. Conversely, a bank can loan its excesses out and get in return an interest payment. That is how a bank keeps its books in line.

The take-away here is that our economic and monetary system is dependent solely on debt and the repayment of that debt. Now, here is the key: this debt based system must always expand. When it stops expanding, it risks becoming a black hole. In order to understand this statement, one should look at the two big risks inherently associated with this debt-based system:

  1. The first risk is a bank run. The banking crisis of 1929/1933 is a perfect example. There was no deposit insurance at that time. When people at a certain point rushed to get their money out of the bank, the money was not there and 80% of banks in the US collapsed.
  2. The second risk is that banks (or their clients) lose money on their bets. Cyprus is a good, recent example. Greek banks owned the banks in Cyprus which all had large investments in Greek debt. When Greek banks got in trouble, Cyprus in turn started accumulating big losses because their deposit base was huge (mainly Russian money). Their 10 to 15 times leverage on that huge deposit base was too big to handle, so it blew up in their own face, and the banks became bankrupt. This is exactly what happens every time when a bubble collapses because the cause of the bubble is bank leverage! When the bubble collapses, the leverage is gone but “it exists in a negative sense”: so much more is owed than ever existed in the first place. This is the black hole of the current economic and monetary system.

Darryl Schoon points out that a black hole does not just happen; it is always there as a potential but only becomes a reality when a bank cannot meet its obligations. Furthermore, money is constantly being fed into the system via debt. Debt is constantly compounding. This creates a necessity for the economy to grow and pay back the constantly growing debt.

From that point of view, it is important to realize that the huge amounts of money being “printed” by central banks is not money that is “sitting in the banking system”; it is merely “debt in motion.” One could compare it with the 1930’s during the Great Depression when people said that “money disappeared.” Such a statement is not correct; it was credit that disappeared leaving only debt that could not be repaid.

This is the best kept secret in our economic and monetary system.

The real issue central banks are facing is the decade low velocity of money. It means that the unprecedented amounts of money being created (i.e. debt being created) are simply not moving. Bail-ins are not solving any issue on that matter; they only allow ailing banks to keep going.

One could rightfully ask the question why bail-ins are only now coming front stage (and not earlier)? Darryl Schoon explains it by comparing today’s situation with the one in the 1930’s. Fundamentally, the system was the same back then. At that time, there were no bail-ins nor bail-outs; the debt-based banking system simply collapsed. Today, central planners are fighting tooth and nail to avoid a collapse.

One final note. Central planners are very focused on reassuring people. It is mandatory that people feel safe or they will stop borrowing. In that respect, savings accounts cannot be removed or the illusion of safety is blown up. Large scale bank bail-ins are not very likely to occur, from that point of view. Central planners will likely print more money to replace any savings lost.

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