Friday, January 6, 2012

Upside Down Asset Pyramid

The Icelandic Banking Crisis is a good lesson for every financial manager to remember.  In a country of 300,000 people the banks grew assets from $1 billion in 2000 to $140 billion in 2006.  Little of this money came from depositors.  Most of the funds came from the issuance of bank bonds.  All of which needed to be paid back with interest.  It was attractive to bond investors to make these purchases since the market prospects for the banks looked so positive.  The bonds looked extremely secure since the bonds paid a 3% interest in Yen or Euros, and money could be lent at 15% in Icelandic Kroner (the prevailing interest rate for Icelandic loans).

Unfortunately, the interest spread is only stable if the currency values do not change relative to each other.  When the inevitable currency collapse occurred the loans in Kroner were returning less than the interest due.  Unfortunately, without a central bank Iceland had no way to protect their currency. Since the bank depositors were making deposits in Kroner and the bank needed to pay back their loans in Yen and Euros the situation only got worse and worse.

Although the poor financial decision making of the Icelandic banks caused the crisis, their decisions like the investments in RMBS during the housing boom of the early 21st century were not egregious or fraudulent.  The time for throwing stones should come to an end and be replaced with a thoughtful strategy to avoid the problems reoccurring.  The easy, but incorrect solution is to throw the bums out.  The problem with that approach is there are always going to be bums.  It is human nature.  What we need is a system that prevents the bums from getting into positions of authority.   That is probably impossible also.  Our next best alternative is a system that prevents the bums from taking advantage of the system.

I suggest we return to the original solution that led to the creation of central banks, spreading the risk.  The original purpose of central banks was not to control the Money Supply or set interest rates or the most ridiculous of all, increase employment, it was to spread the risk of a bank run across the entire banking industry. 

What we are discovering with the European Debt Crisis is even a continent is not larger enough to absorb the losses of a financial mistake of a single country.  Therefore, why not expand the community of banks to include the entire world.  The banking industry could achieve this without government assistance.  It would simplify regulation and with a large Private Sector insurance agency providing the backstop for the banks it would remove government from a business they do not understand and they could focus their resources or building missiles and outfitting Presidential jets.

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