Reality

Leveraging Debt.

Why Banks Don’t Need Rocket Science.

I met a very nice man on one of my occasional visits to Naumburg in Germany. That’s a picture of Naumburg’s mediaeval marketplace up there, by the way. Anyway, he asked me if I knew that banks could create money. I replied that I did. He went on to mention how they could take $10,000 and leverage it. But he didn’t go any further than that. My response was that of the banker: for a banker doesn’t think of this money, for ten grand is a piddling sum to them – they’ve already reverse-engineered this against the interest rate and arrived at how much money this sum will allow them to borrow.

I’ll explain.

Whilst banking seems to be the dark art du jour, the essential principles are astonishingly simple. The banking of today is effectively a misuse of the double-entry bookkeeping system where each transaction is recorded both as a credit and a debit. These balance out to zero – and at the bottom of the page everything’s summed up and the turnover is recorded. Everything else, the slicing and dicing, the rocket-science maths, the shorting of the stockmarket is based on being able to create money.

The key here is to hold a banking licence; this is usual for a bank, but not strictly necessary. After all, the banks are big enough to tell the regulators to sit down and behave themselves. You see, with a banking licence one is allowed to create money. If you’ve created enough money, you can then tell the regulators that you don’t need regulating. Thus on the one hand we have the credit side of the balance book, which goes into the bank’s back pocket. As it were. However, the balance needs to be zero, so a debit is formed to cancel it out. This is borrowed money, and the bank pays the Central Bank the interest on this. A nice little earner! Mind you, that could be why most (all?) central banks are privately owned.

Forget the details! If for the only reason that the details are where the money is, so forget it, okay?

So we have the credit side and the debit side. This means our banker saw the $10,000 not as a mere ten grand, but multiplied by two hundred. That is to say, the amount that ten grand will pay in terms of interest on a sum borrowed. That sum being $200,000.

The bank can invest their credit side – $200,000 in this case – in order to make a profit. I use the term ‘invest’ loosely, as banks use this money to gamble on the stockmarket rather than actually investing it. But that’s how they make a fraction of a percentage point of profit on their credit side – which needs to be more than the interest they’re paying the central bank. What’s left is their profit. If they made (say) $20,000 profit, you can see that half can repeat the process of leveraging and the other half buys a small case of champagne for the Christmas party.

You can quickly see two outcomes to this style of banking. Firstly that current account holders are largely irrelevant in terms of making money. The other side of the coin is that super-low interest rates have allowed banks to leverage massively and invest (that is to say, gamble) unwisely. Tweak the interest rate by (say) a quarter of a percentage point and the banks will be asking for another round of handouts because their balance books have plunged into the red again.

The finance ministries really are at the beck and call of the banks! More dangerously for countries without an industrial base, the banking sector forms the largest proportion of the country’s Gross Domestic Product. Around 60% in the case of the UK and US. Take that away and their economic figures look worse than that of Mali in West Africa.

Good reason to bail out the banks, then.

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2 thoughts on “Leveraging Debt.

  1. Gemma, I sort of get it I think but it makes no sense to me. I’m not completely stupid (I have a medical degree), but this stuff makes me feel dense. It’s just not concrete. Also it defies belief because it’s incredible that it’s going on. Can you imagine being a history teacher in the future and trying to explain it to a class. Of 10. Year olds? If something cannot be explained on that level then it is hard to retain on any level.

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    1. I agree with you about ten year olds; indeed, it is my contention that anything else has very dubious value for humanity.

      It does take a great deal of imagination to speak to a ten year old, and I wouldn’t mind betting that some of your medical knowledge would be very hard to put in a form where a ten year old can understand it easily… but then, if you’ve got kids, it’s not unlikely that you already have!

      As to what one ought tell of our generation as history, I can only say that most businessmen aren’t doing their job – the problem is that because they’re raking in money, they don’t know how bad they actually are at business (see my post on “Meeting A Successful Businessman“). Because I can explain business to kids, in fact, they’re often the best people to speak to because they’ve not had their brains scrambled with all this business school rubbish.

      If you want the truth, leveraging debt is only avoiding hard decisions, in the way Quantitive Easing is. Real business – effective business – don’t need it; and I know several businessmen who see increases in profits of well over 50% annually and have actively engaged staff.

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