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The truths they don't want you to read....

Saturday, September 15, 2007

Banking system

The entire banking system is built on an illusion. But an illusion that works, and one that needs to work to ensure the entire economy survives and grows.

It is also an illusion that every businessman has used at one time or another, and one that every businessman has seen dissolve many times.

The banks don't have your money to return to you. The banks have enough cash to meet the expectations for cash withdrawals any day, plus a bit for a safety margin. As most of us deal with cheques and electronic payments, the daily square up between banks - the money the Royal Bank owes the Bank of Scotland, less the money owed the other way - is a matter of bookkeeping rather than money fivers from branch to branch.

It is also predictable, meaning that the rest of the deposits are lent out to others, usually long term as loans and mortgages.

As every businessman knows, sometimes a business will fail despite it having loads of assets, simply because it has no cash to pay it's bills day-to-day. Businesses trade using the expectation of cash coming in to fund the cash going out; when that confidence fails you are insolvent.

The Northern Rock faces the problem of turning it's long term lending into fivers to fund what is effectively a run on the bank. This problem quickly becomes a vicious circle with the Northern Rock becoming more and more desperate to become liquid to pay exiting depositors, needing to borrow at higher and higher interest rates or sell assets at lower prices.

The danger is that this problem infects the entire system, and other banks suffers the same fate.

The unknown is just how much of this is an underlying fundamental problem such as exposure to the sub-prime market in the US and how much is simply liquidity and loss of confidence. Only time will tell.


Anonymous said...

What I don't want to see if it goes under is a panicky press release by the Comhairle that they've stuffed all our money into Northern Crock, but everything will be okay...

Anonymous said...

Angus, as a person of a little financial knowhow, do u believe the NR customers removing their dough at such an alarming rate are doing the right thing. If they were all to choose RBS as a safe recipient of their life savings would this enable Fred the Shred to use that income to buy northern rock? is this not just a sad indictment of the modern world where
a) 24 hour news needs to be just a tad more edgy
b) banks are just like the rest of us in that they live for the monthly income...although i don't know which is more demanding - shareholders or family

Angus said...

cc, Northern Rock is not insolvent, merely illiquid. Withdrawing your money is totally illogical and exacerbates the lack of liquidity.

Were it my money, I would probably be acting just as irrationally.

The danger is that the loss of confidence moves to another bank and then affects the whole economy.

Sadly, US mortgage companies will have more influence on the Scottish economy than Alex Salmond.

Anonymous said...

All to do with politicians saying 'don't panic' I reckon.

Anonymous said...

good point first anon