Basic question on the banking system

Imposter

With the current crisis in the banking system i've been doing some thinking (don't worry, I didn't hurt myself yet).

What sort or ratio exists between the amount of real money in the banking system compared to virtual money?
For for every 1€ that actually exists roughly how many €'s are being traded? Is it 1:10, 1:100, much more, less?

Am I correct in thinking that the whole readjustments going on now is an attempt to bring this ratio back to a sane level?

edanto

I'm interested in this too.

Thing is though, I think I am ignorant about some very basic concepts in Economics.

Such as what's 'real' money? Is that actual cash that at some point the Central Bank has released in to the system.

What would a good definition of virtual cash be? All the wealth on all the balance sheets? Of a country/in the world?

SoCal90046

Imposter wrote: »

With the current crisis in the banking system i've been doing some thinking (don't worry, I didn't hurt myself yet).

What sort or ratio exists between the amount of real money in the banking system compared to virtual money?
For for every 1€ that actually exists roughly how many €'s are being traded? Is it 1:10, 1:100, much more, less?

Am I correct in thinking that the whole readjustments going on now is an attempt to bring this ratio back to a sane level?

That's an excellent question and it goes to the heart of a very important topic in economics.

Here's a link to a good article on Wikipedia that discusses "Basel II." Basel II addresses the issue of capital requirements. The Basel II accords makes recommendations to central banks worldwide on a host of subjects meant to protect the banking industry. Here's an example of how regulatory authories in the US attempt to comply with the Basel II Accords.

The capital requirements are no longer necessarily a fixed percentage, such as 5 or 10%, of deposits, but depends on the assets that a bank holds. So, if a bank holds an AAA or Aaa rated asset that receives a downgrade, then that bank is required to increase its high grade or cash holdings in short order. In the US, my guess would be that banks hold about 5% of all deposits in cash or cash equivalents. That means that for every dollar deposited, all else being equal, there's the potential to create up to $20 in new money--for want of a better term. Of course, the actual figure is much lower.

Holding cash equivalents is part of the problem that US banks such as Washington Mutual faced: assets deteriorated and were downgraded which meant that banks had to raise cash quickly to compensate, something hard to do in a credit crisis. The problem was compounded by consumers who feared for the solvency of troubled banks and withdrew funds at the very point when banks needed them most. The action taken be regulatory authorities in Ireland to increase the insurance level on deposits was designed to forestall the exodus of capital--other regulatory authorities, such as the FDIC in the US, have followed Ireland's lead and raised the level of insurance on funds. Banks such as WaMu and IndyMac failed because they didn't have access to funds to meet their capital requirements. In the us, once that happens, agencies of the federal and state governments, typically led by the FDIC, seize the bank.

By the way, the Federal Reserve Discount Window isn't availble to banks such as WaMu and IndyMac when they're facing a solvency issue. The Discount Window is available to banks that are going concerns and to cover extremely short term liquidity issues--typically less than 24 hours.

One more point. In the US at least, if a bank fails to meet its capital requirement, it's required to remediate the situation quickly.

edanto

I've only found one reference so far to answer the original question about virtual value and the ratio - have a read and see what you think.

http://www.hartford-hwp.com/archives/25/062.html

It's specific to the area of Foreign Exchange transactions.

"Today, the real economy in foreign exchange transactions is down to 2.5% and 97.5% is now speculative. What had been the frosting has become the cake. The real economy has become just a small percentage of total financial currency activity."

These are important - as Noam Chomsky pointed out in the NYT and IT recently

http://www.irishtimes.com/newspaper/opinion/2008/1010/1223560345968.html

"Financial liberalisation has effects well beyond the economy. It has long been understood that it is a powerful weapon against democracy. Free capital movement creates what some have called a "virtual parliament" of investors and lenders, who closely monitor government programmes and "vote" against them if they are considered irrational: for the benefit of people, rather than concentrated private power.

Investors and lenders can "vote" by capital flight, attacks on currencies and other devices offered by financial liberalisation. That is one reason why the Bretton Woods system established by the United States and Britain after the second World War instituted capital controls and regulated currencies.*

The Great Depression and the war had aroused powerful radical democratic currents, ranging from the anti-fascist resistance to working class organisation. These pressures made it necessary to permit social democratic policies. The Bretton Woods system was designed in part to create a space for government action responding to public will - for some measure of democracy.

John Maynard Keynes, the British negotiator, considered the most important achievement of Bretton Woods to be the establishment of the right of governments to restrict capital movement.

In dramatic contrast, in the neoliberal phase after the breakdown of the Bretton Woods system in the 1970s, the US treasury now regards free capital mobility as a "fundamental right", unlike such alleged "rights" as those guaranteed by the Universal Declaration of Human Rights: health, education, decent employment, security and other rights that the Reagan and Bush administrations have dismissed as "letters to Santa Claus", "preposterous", mere "myths".

In earlier years, the public had not been much of a problem. The reasons are reviewed by Barry Eichengreen in his standard scholarly history of the international monetary system. He explains that in the 19th century, governments had not yet been "politicised by universal male suffrage and the rise of trade unionism and parliamentary labour parties". Therefore, the severe costs imposed by the virtual parliament could be transferred to the general population.

But with the radicalisation of the general public during the Great Depression and the anti-fascist war, that luxury was no longer available to private power and wealth. Hence in the Bretton Woods system, "limits on capital mobility substituted for limits on democracy as a source of insulation from market pressures".

The obvious corollary is that after the dismantling of the postwar system, democracy is restricted. It has therefore become necessary to control and marginalise the public in some fashion, processes particularly evident in the more business-run societies like the United States. The management of electoral extravaganzas by the public relations industry is one illustration."



The quote at the top was from a presentation in 1997, you can imagine that it's all changed since. One massive change was the invention of that time-bomb financial product, the Credit Default Swap.
http://www.newsweek.com/id/161199

What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices.
....
So much of what's gone wrong with the financial system in the past year can be traced back to credit default swaps, which ballooned into a $62 trillion market before ratcheting down to $55 trillion last week—nearly four times the value of all stocks traded on the New York Stock Exchange. There's a reason Warren Buffett called these instruments "financial weapons of mass destruction.

So the connections - a massive amount of virtual value added to a global economic system by the invention of a financial product, essentially a thought experiment.

Chomsky accuses that same economic system of being vulnerable to manipulation by the extremely wealthy when they wish to influence governments.

We've seen governments around the world fall at the feet of the corporates since the fate and wealth of the common person is now so intricately connected with the survival of the banks - even if those that created the system have cashed out a good while ago.

While our pensions, linked to this BS financial system, crumble in value.

We should limit and tax properly the activities of companies in the financial sector.

Économiste Monétaire

Since when has Noam Chomsky been an expert on either economics or financial markets? He is making misleading statements about Bretton Woods. Also, Warren Buffet said that derivatives, as a whole, were WMDs; CDS are not the be all, and end all, of derivatives. CDS weren't created out of a conspiracy--instead argue about their effectiveness, or lack thereof.

Time Magazine

UCD_Econ wrote: »

Since when has Noam Chomsky been an expert on either economics or financial markets?

But he's so popular among non-economists. Surely he's right?

edanto

UCD_Econ wrote: »

Since when has Noam Chomsky been an expert on either economics or financial markets?

Probably since the eighties when he started writing widely about politics.

Economics today has a narrow interpretation of 'finances' when the true definition is related to well being of the citizens, so anyone interested in politics would have a slightly different view of the important aspects of economics compared to the reasonable narrow frame considered by many university courses.

Of course other subjects are touched on - let me support my case by referencing the table of contents of the Mankiw book

http://www.amazon.com/Principles-Economics-Student-Gregory-Mankiw/dp/0324224729

Even though the first sentence of the book translates oikonomos, it's clear that for the most part, the book deals with financial issues.

Saying that Chomsky doesn't know what he's talking about when it comes to economics is shortsighted. He sees how the actions of governments and corporations can impact the lives of people.

The lives of people - that's the thing at issue in economics, not GDP.

Time Magazine

edanto wrote: »

The lives of people - that's the thing at issue in economics, not GDP.

That's also the kind of rhetoric Chomsky is famous for. Economists, believe it or not, are also concerned about people. Economists have a bad reputation in society as free market fundamentalists. This is unfair. The highest-ranked economist in the world is best-known to the public for his criticisms of the globalisation process and Iraq. The number two's specialisation is in behavioural finance - the field that starts off with the assumption that the market is flawed. Number four spends his time in schools in Clondalkin.

However unlike economic commentators of both the left and the right, academic economists' goal is to not be blinded by belief or rhetoric. This is what is required for clear analysis, the conclusions of which can be argued from political perspectives. There's a necessary disconnect there that Chomsky not only fails to adhere to, he revels in merging the two.

edanto

Fair enough.

On the lighter side, I'd be really grateful if you could spend some time making a long post to address the issues raised in the first few posts.

cheers

Time Magazine

edanto wrote: »

Fair enough.

On the lighter side, I'd be really grateful if you could spend some time making a long post to address the issues raised in the first few posts.

cheers

I don't know the answer to the problem. I quite like this post on a blog (about 6 lines long), that sums it up pretty well.

There's a general principle that if people are out to make money, and making money requires stability, then these people will foster stability. Everyone knows that banks have been hit damn hard this past year by over-exposing themselves. The profit motive failed: they failed to protect their profits. Exactly why is hard to explain. My hunch is agency theory: that it wasn't the bank executives' fault per se, but rather workers further down the chain who had a shorter horizon on what it meant to be profitable. An interesting analogy Prof Patrick Honohan has used is where bank workers knew how to "play" security systems, knowing that admitting x would result in a refusal of a loan but focusing on y would help get it through the checks and balances. That's very, very hard to fight against, no matter what system you have in place.

Certainly the initial response to this problem is to think that we need more regulation, with a democratically-controlled banking system. But, unfortunately, that has huge problems too as it causes inflation. And even then, democracy often makes the problem worse. Would you rather consistent inflation depressing growth over decades or one big financial hit? It's hard to say.

The problem, from what I can see, isn't the ratio issue. Stupid loans are stupid loans regardless of ratio. Changing the ratio is likely to prevent "fair" risk of reasonable loans, meaning people able to pay won't get mortgages. Is it worse to have one family lose their house because they accepted a mortgage that they couldn't afford, or another family be refused a mortgage they can afford?

The problem is ensuring that the average bank worker can tell the difference between a good loan and a bad loan, and that they offer only to the former. That has no simple answer.

Économiste Monétaire

The Economist wrote: »

But he's so popular among non-economists. Surely he's right?

It means he has found the link between the lizard men and economists.

edanto wrote: »

Probably since the eighties when he started writing widely about politics.

Political Science and Economic Science are two completely different subject areas.

edanto wrote: »

Economics today has a narrow interpretation of 'finances' when the true definition is related to well being of the citizens, so anyone interested in politics would have a slightly different view of the important aspects of economics compared to the reasonable narrow frame considered by many university courses.

The definition of 'Economics' as a field of study is: a social science concerned chiefly with description and analysis of the production, distribution, and consumption of goods and services. What you're talking of are branches of economics, financial economics and monetary economics.

edanto wrote: »

Saying that Chomsky doesn't know what he's talking about when it comes to economics is shortsighted. He sees how the actions of governments and corporations can impact the lives of people.

It's not short-sighted to say that Noam Chomsky is not an expert in the field of economics--because he isn't. His main body of published research, in an academic setting, is linguistics (he is a professor of linguistics, not economics).

edanto wrote: »

The lives of people - that's the thing at issue in economics, not GDP.

Refer to The Economist's post. We, economists, are not robots, nor are we oblivious to the plight of actual human beings.

To get back on point:

edanto wrote:

I'd be really grateful if you could spend some time making a long post to address the issues raised in the first few posts.

Are you asking about reserve requirements, how the financial crisis began, what central banks are doing and why they're doing it, or... what?

edanto

Just this..

Imposter wrote: »

What sort or ratio exists between the amount of real money in the banking system compared to virtual money?

And excuse my ignorance of your subject - I know I'm being a bit aggressive, but it's nothing personal. Part of it is a frustration with the boring and narrow frame in which economics stories are typically reported on the news, for example - and a suspicion that financial economics is deeply flawed by not properly accounting for externalised costs.

Time Magazine

You're talking in the general region of 50:1 of liabilities to assets for the banks that have failed. Sounds like a lot, and it is, but consider UBS who survived all this turmoil with 47:1.

A Dub in Glasgo

Does anyone really know what the ratio is? What is reasonable? What about the ratio for the banks that have just been given a state bailout? Are they classed as failures?

Not surprising to see this forum constraining the look at economics, after all do Turkeys vote for Christmas?

Économiste Monétaire

A Dub in Glasgo wrote: »

Does anyone really know what the ratio is? What is reasonable?

If you want to take a basic look at reserves to deposits in the Euro area, the minimum reserve requirement is 2%. The Economist has already outlined a parameter of general Assets to Liabilities, and SoCal wrote quite a good reply. Not every bank will be the same--depository institutions and investment banks won't have the same structure.

A Dub in Glasgo wrote: »

What about the ratio for the banks that have just been given a state bailout? Are they classed as failures?

I'm assuming you're talking about Irish banks. No Irish bank has been given a bailout. A 'bailout' occurs when an institution has become bankrupt and the government, and the regulator, step in and take over its operations. That was what occurred in the case of Northern Rock, that has not occurred in Ireland (yet, possibly). The government has proposed a guarantee.

A Dub in Glasgo wrote: »

Not surprising to see this forum constraining the look at economics, after all do Turkeys vote for Christmas?

How is anyone 'constraining the look at economics'?

Time Magazine

A Dub in Glasgo wrote: »

Not surprising to see this forum constraining the look at economics, after all do Turkeys vote for Christmas?

1. "Constraining the look at economics" - what?
2. This forum has never been busier.
3. You'd consider this crisis akin to Christmas?

cabinteelytom

Media reports had it that the Irish Government guaranteed the debts and the deposits of the six largest Irish banks and building societies.
Question:is this true? Will there be no house repossessions because of payment arrears, as the tax-payer will dig out mortgage-holders who get behind in their payments?

Économiste Monétaire

cabinteelytom wrote: »

Media reports had it that the Irish Government guaranteed the debts and the deposits of the six largest Irish banks and building societies.
Question:is this true? Will there be no house repossessions because of payment arrears, as the tax-payer will dig out mortgage-holders who get behind in their payments?

They guaranteed the deposits of the banks, the bonds issued by the banks, and other selected debt of the banks (senior debt and subordinated debt). Loans issued by the bank are not debts of the bank. Basically, if you default on your mortgage, a bank will still repossess your home.