Saturday, February 07, 2009

Thoughts on the Banking Crisis, Invisible Hands, and Risk Aversion

It strikes me that the current banking crisis provides a useful illustration of the behaviour which Adam Smith noted in his famous chapter 2 in Book IV in Wealth Of Nations.

I have quoted this chapter many times here when discussing Smith’s use if the 18th century popular literary metaphor of ‘an invisible hand’, which modern economists since the 1950s elevated into a ‘theory’, ‘concept’, ‘principle’ and even a ‘paradigm’ of how markets work.

Of course, it was nothing of the sort; it became a convenient piece of semi-mystical ideology to propagandise on behalf of leaving large corporate entities to do whatever they found convenient to their interests.

Looking at the political issues around the ‘credit crunch’, the complaint is often presented as the banks being unwilling to make loans to willing borrowers, presumably of good quality, or even to each other. Much angst is suffered asking to why this should be so, given the billions of pounds they have been ‘given’ by various governments.

The answer is partly concealed in the cause of the problem. I refer to the risk-aversion of the banks. They have taken onto their books billions of pounds worth of ‘toxic assets’, most of which neither they nor those who carry them as ‘assets’ are sure exactly as to their true worth. Lending to people with undisclosed – because unknown – liabilities is no way to run a profitable or any other kind of bank.

Borrowers from the general public may receive a trickle of loans, but these are nowhere sufficient to ‘kick-start’ the sluggish economy, and without bank credit flowing more freely, the economy becomes increasingly sluggish.

Borrowers from within the banking sector, even those supported by government loans, guarantees, and assurances, are unlikely to engage in normal ‘inter-bank lending’, while nobody is willing to disclose even to other banks because they may not know themselves the extent of their ‘toxic’ debts, nor their true level of toxicity. This fully explains the current impasse in bank lending.

Hence, the frustration of hapless government ministers, whose complicity in the creation of the mess is as big a secret as are the extent of toxic problem.

But let’s be clear. It is the risk-aversion of the players in the banking crisis that leads them to behave in this manner. They prefer to hold onto what real assets they have rather than commit their business to the uncertain fortunes of lending to both other banks and the wider business community.

Ironically, government borrowing creates an opportunity to buy bonds and earn some interest, though at lower rates than they were used to. But that won’t end the crisis. But banks carry debts owed to them by foreign banks, and what they fear about the risk of their bank lending in Britain is made much worse when considering the security of their loans abroad, where uncertainties caused by doubt and ignorance of the true state of affairs with foreign banks makes them ever more insecurity.

What is true for British banks is also true for foreign banks, all of which was made worse by the swift decision of the Prime Minister and the Chancellor, just when the crisis broke, to seize and confiscate the funds of the Iceland banks in London. Other foreign banks, seeing this treatment, were positively encouraged to disengage their banks situated in the UK. Likewise, British banks’ insecurity about lending abroad is another disincentive to lend.

Adam Smith shows in Wealth Of Nations an analogous situation when noting that some, but not all, domestic merchants preferred to invest their capital locally rather than join those merchants who sought higher profits from trading with the British colonies in North America.

The risk premium, plus long experience of some merchants in the Atlantic trade, was covered by the higher profits they could obtain while their monopoly trade, under the protection of the British Navigation Acts – originally an idea under Cromwell’s remit - and which were enforced by the Royal Navy and every British seaport at home and abroad.

But those merchants, who were risk-averse towards overseas trade, found that local investment, nearby where they operated, though less profitable, were also much less risky. Local courts were serviced by neighbours they knew and laws were clearly defined. These considerations led them to invest locally, which directly benefited the British economy and produced a higher national output of the ‘necessaries, conveniences, and amusements of life’, with a higher amount of employment than would otherwise have occurred. [The whole is the sum of its parts.]

Smith used the metaphor of ‘an invisible hand’ to explain how they were ‘led’ to do this, which has since taken on a life of its own, as if such an entity actually existed; some attribute the ‘invisible hand’ to the hand of God (presumably the hand of the Judaic-Christian God only) and some to ‘Providence’, maybe even to the ‘Intelligent Designer’ too.

The cold fact remains, the action of those, but not all, merchants who preferred to invest locally, was driven by their risk-aversion, and not by anything mystical at all. Likewise, today’s bankers, who hang on to their money rather than lend it out, are driven by their risk-aversion, and nothing else.

There is no invisible hand at work in the Banks. It’s a judgment about comparative risks made by those who run the banks. Change the personnel, but the risk-aversion remains while the causes of it remain on their books.

Meanwhile, the plethora of so-called ‘doing the right things’, in a stream of endless and empty sound bites, creates a complex web of suspicions, fuelled by failures, to have any real effect, and makes it more and more difficult, and unlikely, that the crisis will end for a long and longer time.

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Blogger Advant Guard said...

The problem is not that banks are not lending. The problem is that other sources of funding, such as commercial paper, have vanished and corporations are turning to banks as back-up sources of funding. The banks are lending much more than they planned while at the same time their capital has shrunk as a result of losses. Banks have had to become much more choosy about who they lend to because demand for borrowing has surged while their capacity to lend has dropped.

5:30 am  
Blogger Gavin Kennedy said...

Hi Advent Guard

Thanks for your clarification.

It's a fluid situation at present.

My contacts among lending personnel working in the Scottish banks tell me that their credit sanctioning processes are working at low capacity levels, with very few business loans and mortgages going through (though these are very slightly up this week than they have been for several past weeks).

The reason is that perceived risks are higher - quality loans are very few, demand for loans is quite, even ususually, large.

Commerical paper is down for similar reasons, which I summed as risk-aversion among investers, though not borrowers.

House buyers, who may have cash to buy, are not unaffected by fallling house prices, which encourage delays in buying.

Low interest rates bring marginal house buyers into play, but those who need a mortgage to buy a new house are held back by unwilling buyers for their existing houses, causing a grid-lock in uncompleted transactions.

These amount to a serious dislocation across the market for loans, much of it driven by risk-aversion (rising unemployment; business failures; riskier longer- term exposures).

I take your specific points. I addressed the general problems of the effects of risk-aversion on lending behaviour in this contemporary situation and compared it with the situation alluded to by Adam Smith in 1776.

11:04 am  

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