One answer is that borrowers are simply “tapped out” and not in a position to take out as many loans as they used to. When housing and the stock market crashed, consumers no longer had home or stock equity to borrow against.5 But to the extent that the blockage is with the banks themselves, it is not caused by the reserve requirement. Something else is putting the squeeze on credit . . . .
The Real Tourniquet: Capital Adequacy and the Mark-to-Market Rule
What actually constrains bank lending is the capital adequacy requirement, something that is imposed not by our own central bank but by the Bank for International Settlements (BIS). Called “the central bankers’ central bank,” the BIS pulls the strings of the private international banking system from Basel, Switzerland.
How the capital requirement is determined is even more complicated than the reserve requirement, but it needs to be understood to understand why banks with the power to create money are going bankrupt. So here is a simplified version. A bank’s “capital” consists of its assets minus its liabilities. Under the capital adequacy rule imposed by the Basel Accords, assets are “risk-weighted,” with some being considered riskier than others. Ordinary loans have a “risk weighting” of 1. The capital adequacy rule requires that the ratio of a bank’s capital to its assets with a risk-weighting of 1 be at least 8%. That means the bank must have $8 in capital for every $100 in ordinary loans. Federal bonds have a risk-weighting of zero: they are considered to be as safe as dollars and don’t need any extra capital backing them. Mortgage loans (which are secured by real estate) have a risk weighting of .5. That means they need only $4 of capital per $100 of loans. Other bank exposures given risk weightings include such things as derivatives and foreign exchange contracts.6 (Interestingly, the $700 billion committed by Congress to bailing out the financial system is approximately 8% of the $8.5 trillion the Fed has now promised in loans and commitments. Even the Federal Reserve evidently feels constrained by the BIS capital requirement.)
A very controversial accounting rule imposed on banks for their capital ratio calculations is the “mark to market” rule. This rule requires banks to revalue all of their assets each day as if the assets had to be sold that day. Capital calculations thus fluctuate with the market; and in today’s volatile market, all asset classes have plunged at the same time. Since assets get marked to market but liabilities don’t, a bank may suddenly find that its assets are insufficient to support its liabilities, rendering it insolvent and unable to make new loans. Banks have gotten around the capital adequacy requirement by reducing risk on their balance sheets with a form of private bet known as “derivatives.” At least, they thought they had gotten around the rule. But this unregulated form of insurance proved to be based on faulty mathematical models. (See Ellen Brown, “”Credit Default Swaps: Derivative Disaster Du Jour,” and “It’s the Derivatives, Stupid!,” www.webofdebt.com/articles.)
“Credit default swaps” (CDS) are a form of derivative widely sold as insurance against default. When AIG, the world’s largest insurance company, ventured into CDS in the late 1990s, the presumption was that “housing always goes up” and that the risk of default was so remote that selling “credit protection” was virtually “free money”.7But this free money turned into a serious liability to the protection sellers when the “remote” actually happened and a flood of defaults struck. The value of the derivatives protecting securitized mortgages became so questionable that they were unmarketable at any price. Banks counting them as assets on their books then had to “mark them to market” effectively at zero, reducing the banks’ capital below the levels called for in the Basel Accords and rendering the banks officially insolvent. When AIG went broke in September 2008, banks heavily involved in derivatives faced double jeopardy: not only would they have to write down the derivative protection they had sold to others and counted as assets on their books, but they could no longer count on the derivative insurance they had bought to minimize the risk of default on their other assets. AIG got a massive bailout from the Fed in return for most of its equity, but even that bailout money is not expected to be enough to get it out of its derivative nightmare and keep it afloat.
Derivatives have introduced a lack of transparency into bank portfolios, creating fear and uncertainty on the part of lenders, depositors and investors alike. This uncertainty has prevented banks from raising capital by selling stock, or meeting reserve requirements by getting interbank loans; and it has discouraged investors from investing in the money market. Banks don’t know whether the money they lend to each other will be repaid, since they don’t have a clear view of the value of the assets carried on bank balance sheets. The result is a crisis of confidence: the players are all eying each other suspiciously and holding their cards close to the chest.
Going Local
Fortunately, according to a recent study using the Treasury Department’s own data, the banking crisis is not widespread but is limited to only “a few big, vocal banks.”8The real credit problem lies with the financial institutions with significant derivative exposure, and most of this liability is carried by only a handful of Wall Street giants. In early 2008, outstanding derivatives on the books of U.S. banks exceeded $180 trillion. However, $90 trillion of this was carried on the books of JPMorgan Chase alone, while Citibank and Bank of America each had $38 trillion on their books.9 Needless to say, these are also the banks that are first in line for the Treasury’s bailout money under the Troubled Asset Relief Program. Rather than excising the relatively contained derivative tumor, the Treasury and the Fed are feeding it with trillions in taxpayer money; and this money is being used, not to unfreeze credit by making loans, but to buy up smaller banks.10 That means the derivative cancer, rather than being excised, is liable to spread.
We the people and our representatives in Congress have allowed Wall Street to call the shots because we think we are dependent on their credit system, but we aren’t. There are other ways to get credit -- ways that are fair, efficient, transparent, and don’t encourage greed. Public credit could be generated by a system of public banks. Precedent for this solution is to be found in the state-owned Bank of North Dakota, which has been generating credit for North Dakota since 1919, keeping the state fiscally sound when other states are floundering. (See Ellen Brown, “Sustainable Government: Banking for a ‘New’ New Deal,” webofdebt.com/articles, December 8, 2008.)
The credit crunch could be avoided by “going local” not just in the United States but around the world. Countries that have been seduced or coerced into funneling their productive assets into serving foreign markets and foreign investors could become self-sustaining, using their own credit and their own resources to feed and serve their own people. There is much more to be said on this subject, but it will be saved for future articles. Stay tuned.
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