The End of Banking

The American Banking System is one of the most regulated industries in America.

Since 1935 banks have had to deal with regulations that no other industry has come near by.

Due to these Banking Regulations set up as early as 1935, banks have over the years lost interest in lending per se, and have been forced to enter all other types of financial markets, such as derivative service fees, equity deals anything but straight plain-vanilla loans.

As a consequence banks have also lost interest in credit analysis, and America as a nation has lost its credit intelligence, whose effects can be seen today.

Credit intelligence can be found in only two or three companies such as Moody’s, Fitch and Standard & and Poor’s, and even that is contested today.

In the 70’s courses like Management of Lending, such as those given by Charlie Williams of Harvard Business School were oversubscribed. Today such course no longer exists at Harvard.

Credit training was once considered an important step in a young man’s career, so much so that four Presidents of the United States started out as trainees at Dunn & Bradstreet, Lincoln, Grant, Cleveland and McKinley.

They learnt the Five C’s of credit analysis formula: Character, Conditions, Cash Flow, Capacity and Collateral – which became a subtle art. Today credit is given by quantitative formulas, based on one single variable Collateral.

Because of the banking bankrupcies due to the 1929 crash, banking regulations were devised setting up minimal capital requirements. They established capital adequacy ratios in order to prohibit banks from lending more than four to 12 times their capital plus retained earnings.

The latest versions of these capital adequacy ratios are now worldwide, embedded in the Basel I and Basel 2 agreements.

But the bank regulators of that time, did a poor regulating job, by creating rules that would not stand up the test of time.

There is a flagrant mistake in this rule, which would slowly destroy world banking lending capacity over the next seventy years.

Regulators did not take into account future inflation.

An inflation that over the next seventy years would slowly erode the capital base on which the banking systems rest. A 4% inflation rate multiplied by 12 reduces banks lending capacity by 48% of their capital base. In a single year!

Basically what regulators did, was to establish lending limits tied to the following ludicrous and dysfunctional banking rule.

Banks ought to be limited in their lending to 12 times their inflation-eroded capital.

In years of especially high inflation, banks were required to recall many of the loans outstanding in order to comply with this ludicrous banking regulation.

In years of low high inflation, retained earnings would allow them to maintain their current loans outstanding and even increase them, but always losing market share.

With today’s capital base worldwide at around $200 billion, factor in a 4% inflation multiplied by 12, and you will discover that banks worldwide will be constrained to reduce loans outstanding to the order of $2 trillion in 2009 and 2010.

That will be on top of the estimated $200 billion write-offs, which will also be multiplied by 12, reducing loans outstanding an additional $2 trillion in order to comply with bank regulations.

Now answer this question: was this crisis caused by corporate greed and management bonuses, or by faulty legislation?

Are we in the face of a credit crunch, illiquidity, or is there a regulation forcing banks to withhold credit?

It is frightening to realise that academics such as Milton Friedman, John Maynard Keynes and John Kenneth Galbraith all of who wrote extensively about 1929 and banking regulation, should have overlooked such a simple regulatory mistake with such an impact on banks lending ability.

Which also applies to subsequent Nobel Prize winners, any one of which would never agree to tax brackets not adjusted to inflation from time to time.

Unfortunately, none of them are versed in accounting, in countries where inflation was double digit.

Granted that inflation rates were low, and retained earnings of banks were high at the time, banks were allowed to grow though not at full speed. But in 1982 when inflation in the United States reached 20% over a two-year period the effects were devastating.