Wednesday, 27 March 2013

Schroedinger's Cash

It seems there are remarkable similarities between banking and the famous thought experiment intended to demonstrate the Uncertainty Principle.

Savings are both held by the bank and used to make loans - and you can only be certain whether the money is there or not when you 'open the cash box' to withdraw it. 

Certainly that is the way Northumberland Credit Union works, the loans we make are from the capital we hold as members' savings - and it is a matter of fine judgement predicting the amount we can lend against likely demands for withdrawals - at present we have around 68% of savings out on loan, and we reckon that we could lend out maybe 85%. But our members repay weekly or monthly so the money comes back in steadily, and since people know that if they default, they are effectively stealing their neighbours' savings, we don't get that many bad debts.

On the other hand, banks have been tending to go for riskier loans because they get a higher rate of return (if and when they are repaid) and can lend out their 'capital' ie the money in their customers' current and deposit accounts several times over - on the assumption that the cash box will never be fully opened.

And of course - the government will fund the compensation scheme repaying customers' savings (up to £85k) for both banks and the credit union, if the cash box is opened, everyone suddenly wants their money back, loans aren't repaid and the bank (or credit union) goes bust. In other words, savers will get a bit of a tax rebate.

But now the government and the EU are asking the banks to 're-capitalise' - that is find extra money to cover the losses they've made when the high risk loans they've made defaulted. And there are really only two ways to get 'capital' in - one is to borrow more, which is just digging yourself deeper into a hole (so is really only an option for sovereign governments not banks) or to take in more deposits. But then, those deposits could in theory be withdrawn by both the new depositors and by the existing depositors whose money was lost when the original loans weren't repaid. In other words, the banks' capital is never really their own money.

This situation is quite different and should not be confused with illegal 'ponsi' schemes much loved of confidence tricksters, where money deposited by would be savers is used to pay high interest rates to pre-existing savers rather than investing it.

Of course - I'm not an economist so I may have this all totally wrong... 

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