Banking and Systematic Risk
John Kutyn
It should be apparent, even to a disinterested observer, that the global financial and economic systems are breaking down. Various solutions are being offered to fix these problems, in order that people can continue to enjoy the fruits of technological advances. Some economists may even suspect that the financial and economic systems are somehow interrelated, with the deceleration in economic activity being caused by the breakdown in the global financial system. Economists may be on the verge of overcoming the limitations of economic thought that sees economics governed by some natural law that is totally independent of the financial transactions by which commerce actually takes place.
Various theories are set for to explain the root cause of global financial problems, and many of these theories contain an element of truth. However, none of these theories questions the stability of the banking system itself. That is, does the very nature of the banking system create a dysfunctional financial system?
To answer this most important question, one must first look to commercial law, and examine the legal nature of the financial instruments by which banks lend money. Virtually all bank loans are advanced by the credit of a bank account, or the creation of some type of bank liability. A bank account is a financial instrument, being evidence that the bank is in debt to the holder of the bank account.
The legal nature of financial instruments is complicated. A party to a financial instrument incurs liability due to that party being in debt, or as a surety. For example, if A lends money to B, and B gives A a promissory note, B would be the primary debtor on the promissory note. If A transfers the promissory note to C, then B would owe C the money.
However, if B was not in debt to A, B signs the promissory note as a surety for A. As between A and B, there is no legal liability created by signing the note. If A were to transfer the promissory note to C, then it would be A, and not B who would be the primary debtor. If A pays C, the note is discharged, and if B pays C, B has a legal right to repayment from A.
Now consider the legal nature of the credit to the bank account under the pretence of lending money. Is the bank incurring liability on the bank account because the bank is in debt to the holder of the bank account, or is the bank a surety for the holder of the bank account? Put differently, in crediting the bank account, was the bank in debt to the holder of the bank account on some transaction? Since there is no underlying transaction by which the bank is in debt to the holder of the bank account, in crediting the bank account, the bank is a surety for the holder of the bank account. As between the bank and the holder of the bank account, there is no legal liability created by the credit to the bank account, and if the holder of the bank account were to transfer the credit to the bank account to a third party, then the holder of the bank account would be the primary debtor on this liability.
A similar legal argument follows with regard to the legal liability on the promissory note given to the bank. If A gives a bank a promissory note, is A incurring liability because A is in debt to the bank, or has A signed as surety for the Bank? Is there an underlying transaction by which A is in debt to the Bank? All the bank can point to is a credit to a bank account. Due to it’s very legal nature, a credit to a bank account can never make the holder of the bank account in debt to the bank. A credit to a bank deposit represents evidence of the bank being in debt to A, or the bank acting as surety for A, neither of which are underlying transactions by which A is in debt to the bank.
As between the bank and A, there is no legal liability created by the promissory note, with A signing the promissory note as surety for the bank. If the bank were to transfer the promissory note to C, the bank would be the primary debtor on the promissory note.
By crediting A’s bank account, the bank has deceived A into believing that A was in debt to the bank. Based on this deception, A gives the bank a promissory note, and makes loan payments to the bank. The bank profits from these transactions since the interest earned on the promissory note is higher than the interest paid on the bank deposit. This is the legal nature of banking.
However, how do these transactions affect economic activity and the stability of the financial system?
The first point is that these transactions result in an increase in the claims on money without a corresponding increase in actual money. Since, in theory, these transactions can be repeated, virtually without limit, a very serious distortion can occur between actual money, and total claims on this money. The creation of a bank deposit creates a claim for money to be repaid. The creation of a promissory note creates an additional claim for money to be repaid. As the volume of these transactions increase, the total value of legal claims to pay money will far exceed the level of money. Such a financial system will only function so long as there is not a legal demand to full-fill the contractual terms created by these transactions. Holders of bank deposits must not ask for the repayment of money, but must circulate these bank deposits as currency in lieu of money. Promissory notes must be repaid with the issuance of new promissory notes. Since the contracts creating these transactions generally call for some payment of interest, what is due in the future will be greater than what was received. This creates a bias towards an acceleration of the increase in these debt obligations.
These transactions can also have significant macro-economic effects. A credit to a bank deposit allows the holder of the bank deposit to acquire some goods or services in the community. These transactions create a demand for goods that would not have existed without these transactions. In essence, the creation of currency is a source of demand for goods and services, thus affecting economic activity, or what is now called Gross Domestic Product (GDP). Secondly, the repayment of the promissory note results in the person who repaid the promissory note forgoing expenditures on goods and services, and thus reducing economic activity or GDP. Another way of viewing the economic effect of these transactions is to consider a person who earns $1000 from wages, and if the whole amount is spent, contributes $1000 towards GDP. If this person in addition acquires new bank deposits of $200, (and in return gives the bank a promissory note with an interest rate of 10%), this person can spend $1200 and contribute $1200 towards GDP. However, when the promissory note is repaid the following year, this person can only spend $780 ( $1000 income less $220 to repay the promissory note). This person only contributes $780 towards GDP compared to $1200 the previous year, contracting the economy.
Assuming the promissory note is repaid by a debit or reduction to a bank account, this effectively reduces the currency in circulation. From an economic perspective, the additional demand for goods or services created by the original credit of the bank deposit will be less than the reduction in demand for goods or services as the result of the repayment of the promissory note by the debit to the bank deposit. Thus, in order to maintain economic activity at the previous level, each year the bank must give new loans and create new bank deposits equal to principle and interest payments on existing bank loans. Under issuance will decrease, and over issuance increase economic activity. Due to the effect of interest, for constant GDP, the value of the promissory notes and bank deposits created must be greater than the value of the promissory notes repaid.
Essentially, for income to remain constant or increase, bank loans must increase at an accelerating rate. A financial pyramid is created. Debt is generally to be repaid from income. Since the very nature of the system requires that debt must increase faster than income, over time financial strains will eventually implode the system as increasing loan payments exceed available income. Moreover, any attempt to repay debt will contract income, making the repayment of debt a mathematical impossibility.
There are two main factors causing a dysfunctional financial system. The first is the use of financial instruments as currency. The second is the charging of interest. Failure to address these issues in an appropriate manner will now result in the complete collapse of both economic and financial systems.
The present financial system is a pyramid scheme and can not be fixed. What is important is that a proper financial system be created before the present financial system causes severe damage to the underlying economy. A proper financial system would make the charging of interest illegal, and currency exchanges would be restricted to government created money. Given technological advances, most of this money should be created electronically, allowing for electronic transfers. In essence, a government owned bank could be created where each bank account represented actual money.
The change from the present system could take several forms. A simple solution would for the government to purchase all of the bank’s assets by creating money which is credited to the bank’s account with the new government bank ( this is substantially different from present plans to purchase bank assets by creating government debt). The government could then forgive this debt. Present bank account holders could then ask the banks to transfer the money they received from selling their assets to their new accounts with the newly created government bank. As a community, debts would be eliminated, the financial system would be stable, and banks as we know them, striped of both assets and liabilities, would cease to operate. These transactions would not be inflationary as no new money is created, what has changed is what is used for money.
Present government actions to stabilise the financial system by creating government debt and giving government guaranties will not stop the collapse of the financial system, as it does not address the underlying problems, and in fact compounds them. Soon governmental finances will break down with increasing demands to bail out both the financial system and economic systems from a declining tax base. These policies may provide some stability to the financial system, preventing an immediate collapse. However, unless the banks aggressively increase new loans, the underlying economic system will collapse. Falling incomes and asset prices will then result in even greater loan delinquencies and bank loan losses.
Given the serious deterioration of both corporate and personal income and balance sheets, it is not likely that banks will expand lending to those that can not afford to pay back present loans. A cycle is created in which problems in both the financial and economic systems feed off each other, driving each other to collapse.
This shows the major problem of using financial instruments as currency, thus making the currency of a nation entirely dependent on credit cycles. These difficulties are compounded when financial instruments used as currency are not created based on underlying transactions.
In order to understand these issues I have written two papers. “Nature of Money” looks at our financial system from the perspective of both commercial law and economic analysis. “Legal Issues Concerning Bank Loans” contains a more detailed analysis of the legal enforceability of bank loans.
John Kutyn
22 October 2008
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