A Real Solution: One Dollar Of Capital – It’s Catching On

Now we’re talking.

The amusing part of this little ongoing crap-pile will be whether or not any of the folks who now are advocating something similar or functionally identical to what I’ve been hollering about since this entire mess began will credit it where due.

I bet not, but that doesn’t change the facts.

In recent decades, governments and central banks around the world have developed a consistent pattern of behavior when trouble strikes banks that are large or interconnected enough to threaten the broader economy: They step in to ensure that all the bank’s creditors, not just depositors, are paid in full.

As I noted in Leverage this pattern began with Continental Illinois.  When it failed even though some of the executives were prosecuted the FDIC (government) stepped in and protected the bondholders from losing money — not just depositors.  They did so even though there is no mandate under Federal Law for them to do so.

And from that point on the market was on notice that there was no risk “lending” to any large financial institution.  In other words the “interest” you got wasn’t actually interest (the charge to borrow capital, accounting for the risk you might not get paid back) but rather was a straight-across subsidy.

Like all subsidies, the taxpayer largesse distorts supply. If the government supports corn farmers, you get too much corn. If the government subsidizes banks, you get too much credit. As of March, households, companies and government in the U.S. had amassed debts of $38.6 trillion, or 2.5 times the country’s gross domestic product. That’s up from 1.3 times in 1980. The picture is similar in the euro area, where debt outstanding is 1.8 times GDP, double the level of 1995.

The oversupply of credit — also supported in the U.S. by government-backed lenders Fannie Mae and Freddie Mac, and by tax breaks on mortgage interest — encourages risky behavior. People buy houses they can’t afford, companies borrow too much for acquisitions, and banks employ excessive leverage to boost the returns they can offer their shareholders. The result is abloated finance industry: As of 2011, the sector accounted for 8.3 percent of the U.S. economy, compared with 4.9 percent in 1980.

It also makes prices go up due to the basics of supply and demand.  In simple language there is “too much money(ness) chasing goods and services” and as a result prices rise.

But we are continually told this isn’t “inflation” and that allowing that bubble to deflate would be “bad.”  This is a lie, by the way; that which was artificially created shouldn’t be maintained through continually-larger artificial subsidy!

And don’t kid yourself — it has to be ever-larger in subsidy too, because no matter how small the rate of interest it’s not zero, and therefore the amount of subsidy compounds over time.  This evenutally exceeds the ability of the people to pay or the economy to maintain the subsidy and then there is a bust.

Wash, rinse, repeat until destruction.

The solution: Minimize the subsidy. Require banks’shareholders to put up enough capital to make bailouts highly unlikely (we advocate 20 percent of assets). Allow some creditors to take losses when a bank gets into trouble, so they won’t assume they’re safe (an approach regulators in the U.S. and Europe are considering). Cut off subsidies to traders, such as the folks in London who lost billions for JPMorgan, by forbidding speculative trading activity at banks (the goal of the Volcker rule in the U.S. and financial ring-fencing in the U.K.).

Close, but not quite.

The solution: One dollar of capital.

That is, for each dollar of credit that a bank extends it must have on it’s books either a dollar of immediately reducable to liquid asset or a dollar of actual capital.  Capital is either (1) borrowed from the market and is 100% “at risk” (e.g. through the sale of bonds), it is (2) exchanged for equity (ownership, aka through the sale of stock) or (3) it is retained cash earnings from previous business operation.

In practice this means that a bank can extend a loan for the immediately-reducable market value of a house (or a car, or a commercial letter of credit) without holding additional capital.  However, for any dollar of loan that isnot immediately-reducable (yes, this is the “fire sale” value!) it must have one dollar of capital behind the loan.  For an unsecured credit line (e.g. a credit card, a student loan, etc) it must have the entire outstanding balancein capital.  For a derivative position every dollar of underwater position must be backed by one dollar of capitalirrespective of claims that someone else can pay them via an offsetting position unless there is proofavailable that the other party can pay the offset.  In practice this means that the sort of monstrous “notional value” derivative transactions would not take place since forcing the hedge funds and similar to post up a dollar for every underwater dollar on each position every night would effectively end the abusive practices we observe today.

Bluntly, it makes this sort of abuse possible:

and on a quarter-by-quarter basis, this:

It is mathematically impossible to expand credit faster than GDP on a continuing basis and have the outcome be stable.  Such issuance is economically indistinguishable from counterfeiting of the currency in question and since it is an exponential function the destruction of purchasing power occurs at an expanding rate until the remaining purchasing power in the economy is insufficient to make the payments.  Then we get 2008 — and if we don’t cut this crap out here and now we’re going to get something much worse than 2008.

Note that deposits are not capital and do not count; a deposit which can be withdrawn immediately (whether under penalty of some amount of interest or not) cannot be lent as it is effectively a bailment.  If a bank wants to lend your deposit out it has to contract with you for a time-certain to have access to your funds and you must be fully exposed to the risk of losing the money.

This is not, by the way, what some people call “full reserve banking.”  Full reserve banking is in fact 200%reserve banking!  Consider that if you lend someone $100,000 to buy a house that is worth $200,000 on the market in immediately-liquid form (e.g. in a “fire sale” asset liquidation) requiring the bank to hold $100,000 in capital against that loan requires them to effectively hold twice the capital — once in the mortgage note, andagain in capital.  If you do that all lending becomes unsecured in an afternoon (because nobody in their right mind would lend “secured” when the security is not recognized as having value!) and the follow-through effects return commerce to roughly the level of the 1500s in an afternoon.  That is both stupid and unnecessary.

One Dollar of Capital folks.  You heard it here on The Market Ticker years ago, and now, on 6/19/2012, you’refinally seeing people wake up to why it’s so important.

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