Banks’ toxic debts aren’t their main problem

Toxic debts are a problem, a huge one; it's just that there's a systemic problem with the banking world that's much bigger.

Fractional reserve banking means that banks have to keep a proportion of the funds invested with them as a reserve but the rest they can lend out. As the companies they lend to recycle this money to the banks, this means it can be leant out multiple times. If the reserve requirement is 10%, for example, this means that £1 deposited in the banks can allow them to lend £10 to industry. It sounds like voodoo but, in fact, it works well and has been the secret of our prosperity since the industrial revolution. The banks are essential catalysts in helping businessmen literally create wealth, to the benefit of all.

In the old days, people would deposit with a bank and that same bank would lend to people. If the borrow defaulted, the bank usually ensured the borrower had enough collateral to cover the debt and the bank was protected. As the money supply chain was short, it was also efficient.

Nowadays, multiple intermediaries are used. For example £1 invested in a bank A, which is then lent through banks B, C and D with each of them reserving 10%, means that the end customer only borrows 66p from bank D. The upside is that the banks are now much more profitable as the interest rate available to customer goes up. As they take turns in being in different parts of the chains and also trade with their own subsidiaries they can also charge interest multiple times. Not only is profit increased but also the risk is apparently reduced, as instead of investing in a risky customer, banks A, B and C have instead invested in B, C and D respectively, none of which has never defaulted, have good official capital ratios and therefore excellent credit ratings.

The problem comes when the end customer defaults. Because he was only lent 66p in the first place, he cannot really be asked to repay more. Worse, this 66p needs to be spread between the four lending banks in the chain. So bank A, instead of getting, say 81p back for 90p invested is now only looking at a quarter of the 66p. That is about 16p or just 18% of the sum at risk. Now, in isolated defaults, the remainder should come from the other banks in the chain, from their reserves. But in the case of multiple defaults, this is unlikely to happen as the banks on average will have shared this risk between themselves.

If this model were to apply to RBS, for example, which has £2 trillion of assets balanced by £2 trillion of liabilities, then the real value of these assets under default conditions is only actually about £360 billion. Actually, it's worse than this because most banks have invested disproportionately in property as the end customer. Many of these assets will be worth only half of their face value even in the long term. This is the reason the banks say they cannot value their assets. The truth is too scary.

In effect, therefore, the banks have taken higher profits for much higher risk. They are not technically insolvent, as the new CEO of RBS claimed the other day; they don't have a cat's chance in hell of making ends meet in the case of a generalised default by even a small group of customers. They have geared themselves up, meaning that instead of generally getting 90p in the pound from a defaulting customer, they are lucky to get a fifth of that.

Worse still, the banking supply chain has sucked not just people out of more productive industry but also working capital. This is the reason that Britain's growth rate has been so poor compared with China, despite the apparent prosperity and stability, which would normally be ideal conditions for growth. Also the money supply is shared around a much smaller number of end customers, meaning that each one is more important, creating greater instability when one customer does default.

The banks have made a mockery of regulation by changing the structure of the industry, meaning that capital ratios and other key metrics have lost their meaning.

The solution is to do the opposite of what the government is doing. Instead of lending to the banks to reflush their supply chains so they can continue to lend to each other, government lending should be restricted to end customers at no more than one remove. Instead of creating a new government owned 'bad bank' with all the toxic debt, all the existing banks should be treated as bad banks. This will force them to collapse their extended supply chains and focus once again on end customers. High Street banks should be forceably demerged from investment banks to protect the public as most investment banks will go bust. They should be replaced with new local bank managers, seeded with public money if necessary. These people should replace the government owned Business Links and be run for profit. The overall effect of this, whilst painful for bankers and their employees, would be to release huge amounts of capital back into the economy, capital that is currently stuck in a banking supply chain held up by frozen wholesale markets.