European & US banks in deep trouble

Christopher Hire March 19th, 2008
COMMENT, Cities & Regions, Economic Downturn, Economics, Europe: North & West, Features, Germany, Politics & Diplomacy, USA, USA & Canada, [English], innovation

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COMMENT, EU, USA — Most of the focus in the recent crisis has been on the USA and Federal Reserve.

But the banking crisis is far broader than the USA. The German economy in Europe is in a few key ways closest to the US model. And German investment banks are close to collapse, according to De Spiegel.

“(Dusseldorf bank) IKB was on the verge of bankruptcy, with its supposed wonderful US investments worth little more than the paper it was printed on.”

De Spiegel International, 20th February 2008

German and US Banks in trouble

German bank CEOs are not as over-paid as US counterparts, and the banks are often state-backed. Even there various financial people see that they can gamble, and they will always be bailed out.

By the Fed facilitation of the bail-out of Bear Stearns, the US has more or less said the same thing. Take the risks in the good times, the Government will take responsibility in the bad.

People pay for their poor choices, investment bankers are paid for by people.

Germany is a core part of the EU common market, and of Europe. So Germany is an important economic state, equal to the USA on some measures.

As one commentator said, Hope is not a Strategy

The Fed cut interest rates a time 0.75%, in an attempt to stimulate the economy, in the hope it has reached bottom.

It hasn’t. It can’t.

So this cut will not bring even temporary reprieve.

A better strategy would be to stop making it worse by transferring risk from private to public.

And then to ask the question, why do investment banks have so few controls? Even Milton Friedman believed that government needed to act as umpire in business…

“Banks just make money…”

Because basically whilst all the business press gushed over the banks and banking CEOs in the investment bank sector, many of the deals are no better than paper schemes.

Like those 1920s paper pyramids, that Warren Harding, Coolidge and Hoover oversaw.

This happens time and again because many on the far-Right believe that all business needs is for government to get out of the way. This flawed belief, that banks just ‘make money’ if left alone, is naive in the extreme.

It confuses ‘liberty’ with ’safety’.

Banks do make money, as anyone can with unlimited borrowing, but as you’d expect lack of regulation leads to the present uber-high levels of leveraged gearing and risk. If no one tells you ’stop’, greed is a powerful motivator…

I have book here on my shelf, written in 1935 by G.S.Riley in London called “Building Society Practice”. This work simply explains how building society (and bank) loan and customer portfolios work.

Most of those under 35 who are involved in an investment bank should read it. Most only understand recent history, or deals not basic banking. Paper schemes in other words.

Pass-the-Parcel….

Schemes that work in a rising market, as the schemes reinforce the rising trend in a rising market.

But conversely, schemes reinforce the downside trend.

These deals are highly leveraged, and like the mortgage risk industry are about playing ‘pass-the-parcel’. Unfortunately, the parcel of risk gets larger as it groans under the weight of each recipients fees and interest.

Why would you take loans from people who can’t pay, unless you managed to pass-the-parcel of the risk?

Which is what US banks did, but the level of risk in these mortgage-bundle transactions just mirrors the level of risk in many investment bank paper deals.

That’s why it’s unravelling, too much unacknowledged risk in USA & Germany, a sense of inevitability, and a case of what industry people call moral hazard as bank executives do not pay for their mistakes personally.

The leverage, the artificial paper wealth, greed and avarice are why the bankers are creating this whole financial crisis.

But the crisis arose simply because no one is regulating the banks on risk. And those years of excellent returns were artificial as real productivity did not grow in line with inflated profits.

‘Deal’ wealth, not Real wealth

And ultimately labor productivity, gains in economic organization, enabling technology, reduction in costs and other basics create greater wealth.

Real wealth is made in the factory, on the farm, in the lab, in the workshop. Banks must have a social responsibility beyond the deal, to assist in creation of real wealth.

The problem is that recent wealth has been ‘deal’ wealth as outline previously here.

So when people say that fundamental conditions are good in some industries they are telling the truth. Business creates real wealth, banks facilitate business transactions. But US, German and many banks have been watching the ‘deals’ not real business.

The Lesson for Government

But banks perform such a fundamental role in financing business, and funding consumer purchases of business products, that when they get in trouble… we are all in trouble.

Banks perform many investment roles that are of national and global importance.

Banks need regulating with regard to acceptable levels of risk, as those who run them have less to lose from market failures than the ultimate parcel-holder, the taxpayer.

Without regulating banking in the area of risk, this will occur again.

Christopher Hire:

Author of the Global Innovation Review, and Chief Editor of this journal. Focussed on innovation, innovation cities and positive social change globally.

COMMENT, Cities & Regions, Economic Downturn, Economics, Europe: North & West, Features, Germany, Politics & Diplomacy, USA, USA & Canada, [English], innovation
banking, Bear Stearns, finance, ideas, interest rates, investment banks, Merrill Lynch, regulation, Reserve, the Fed

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