In his second instalment of “It’s gold, Your Excellency” (read part one here), Patrick Laure continues his deep dive into modern money creation; this time turning to the role of commercial banks, the limits imposed by prudential rules, and how the failures of these safeguards led to the subprime crisis and today’s global vulnerabilities…
Money creation through credit is also a matter for private banks.
The Cook ratio
A state’s commercial banks can also act as money creators on behalf of and under the control of the state to which they belong.
They follow the same prudential principle as their Central Bank (which is also their supervisory body).
They can thus create money through credit, at least through the interest generated by the credit and the amount of repayment it induces.
So, if I borrow €100 at a rate of 10% over 10 years, I will repay €180 to my bank. The bank will therefore have created an additional €80 in money through me.
The prudential principle that banks must adhere to is expressed by the ‘Cook’ ratio, which stipulates that, as a commercial bank, I can make loans to individuals or businesses up to 11.5 times my own funds, which themselves depend on my customers’ deposits (i.e. 8% deposit for every £100 lent).
Thus, a bank with €1 billion in capital (linked to its customers’ deposits) can lend up to €11.5 billion and create nearly €5.75 billion in additional money, which will increase the money supply. (It’s a little more complicated than that, but that’s the basic principle) .
All of this is well controlled.
To such an extent that when there are financial crises (decline in deposits due to devaluation), banks are required to ‘recapitalise’, i.e. find deposits or ‘settle loans’ to guarantee their outstanding loans. Thus, default is a problem (solvency) but also of creation without compensation…
They are also required to lend money (loans) when the State helps them to recapitalise. They are also subject to risk control, known as ‘stress tests’, and no banks are exempt from this, under the regulation of the ECB, the FED and other central banks.
We are familiar with this situation through the statements made by heads of state on this subject since 2009 and to this day.
Returning to subprime mortgages, as the United States does not have these constraints, it has been able to inject capital into commercial banks (which, on the other hand, are subject to the Cook ratio). These commercial banks were able to offer loans to individuals without worrying about their creditworthiness or their deposits.
But if American commercial banks have the same constraints as we do, why did the subprime crisis happen?
Given the nature of the American system and the ingenuity of financiers, commercial banks were able to “securitise” their debts, i.e. sell Mr and Mrs Johns’ loan to a German or French bank, thereby allowing them to “remove this debt from their Cook ratio constraints” (more simply, ‘take it off the balance sheet’ or ‘off-balance sheet’ entries), then offer another loan, and so on. We know how it ends.
The property market declines, the banks demand repayment, which does not happen, and the German bank at the end of the chain makes provisions for a loan it did not even make!
And the central banks, led by the ECB, in order to prevent the system from collapsing, inject capital (while respecting their reserves) into commercial banks so that they can recapitalise (2009-2010).
But to ‘make a point’, the US Central Bank (the Federal Reserve) allowed one bank, Lehmann Brothers, to collapse by not helping it to ‘recapitalise’.
Are subprime mortgages a thing of the past?
Yes, but the risks are still there, with the same cause (creation of money without collateral) and different consequences (cryptocurrency is not part of the money creation process and its associated risk, see below).
The cause is the issuance of dollars without collateral, no longer for individuals who buy their homes without money, through commercial banks, but for the American economy as a whole, which issues money without restraint.
The United States is injecting billions of dollars to ‘kick-start the machine’, betting on a strong recovery in its economy. These new US dollar issues go by the sweet name of ‘quantitative easing’ (literally ‘quantitative facility’…easy money?)
The risk is that US growth will be so weak that the US dollar will depreciate over time. It should be remembered that foreign central banks use US dollars (foreign currency for them) in exchange for their own national currency.
Thus, a significant decline in the value of the US dollar could compromise peripheral economies. This would force the central banks of these other countries (including ours, of course) to either limit our own currency issuance, devalue our own currency so that exchange rate differences do not undermine our ability to issue currency, or sell US dollars, which would only make the situation worse.
So, what should be done?
We must hope that the US economy returns to growth rates above 4.5%, which is the minimum required for the US dollars flooding international capital markets to remain viable in value.
Capital flow controls must be more effective than they are today, in particular by limiting the inflow of dollars into developing countries.
Finally, and quite simply, the Federal Reserve should only be allowed to print money if it follows the same prudential rules as other central banks around the world.
To sum up, the end of ‘easy money’ is mainly because there are no more wars to finance.
Today’s wars, and this is a good thing, are called ‘economic’ and, paradoxically, the US dollar, which is the ‘essential weapon’ in this economic war, is the most vulnerable weapon in the strongest-looking army.
But new wars are coming and need to be financed, and our financial system is once again entering into war dividends, after a period of peace dividends.
Patrick LAURE
Secrétaire Particulier
+33 6 35 45 27 02
laurepatrick@wanadoo.fr
**The information provided in this article is for general informational purposes only and does not constitute legal advice. It is not intended to create an attorney-client relationship. Laws and regulations vary by jurisdiction and may change over time. Readers should consult a qualified legal professional for advice specific to their situation. The author and publisher are not responsible for any actions taken based on this information.
