Saturday, December 3, 2011

commercial banks(like ibanks) can create stress on central bank

http://www.bbc.co.uk/news/business-15869945 is an enlightening article.

A regulated savings bank (Say BS-Bank) is a private company but a "privileged" company. Privilege is granted by the central bank (tax payer funded) because of the "public service" nature of this company.

The privilege is a huge guarantee (by the central bank) that if careless loan officers give out many bad loans and lose 99% of the money at BS-Bank, retail depositors will be 100% "covered" by central bank when they withdraw.

To understand the rationale, let's understand the basic risks facing a bank. Suppose BS-Bank takes in $5B deposits and lends out $25B (fractional reserve banking). If depositors panic and queue up to withdraw, BS-bank runs out of cash. As soon as it fails to hand over a single cent demanded by a depositor, BS-bank is considered insolvent and bankrupt. Such things happened in the 1930's. Since then, most governments provide that guarantee.

A bank is providing a "public service" -- collects deposits from the public and lends out to home buyers, students, small local businesses, local and central government bodies... Therefore, Government feel the need to prop up all such banks. Note investment banks aren't banks.

The irony in the guarantee -- As a private company, a greedy and chaotic bank can take excessive risks, but tax payers (through the central bank) bear the consequences. "taxpayers will provide a buffer to absorb the banks' losses", says the BBC article. That's why these banks are regulated, but I don't know how effectively.

You might ask how the central banks can "absorb" all the losses. Well it can create money out of thin air and lend to the bank. No free lunch -- currency devaluation; inflation; more Treasury bond issues; higher interest cost to the government; ..

Now I know both unregulated investment banks and regulated commercial banks can create stress on central banks.

p.s.
In 2008, Singapore government basically extended the guarantee beyond retail to all depositors of Singapore based banks.

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