I had a very interesting conversation with my colleague Peter Mathews TD earlier this week regarding one of the core causes of our banking bubble.
It was all in the context of the various banks coming before the Dail Finance committee this week.
Peter pointed out that we had reckless bankers who broke one of the fundamental rules of banking when it came to “Fractional Reserving”.
Confused? Well you are not the only one!
Firstly, fractional reserving is where a banking system only holds on to a fraction of its bank deposits in actual cash-on-hand that is available for withdrawal. This fraction that is held by the bank determines how much money the bank can, or should, issue in loans.
Most banking systems in the world operate under this type of system, which is done to expand the economy by freeing up capital that can be loaned out to other parties.
How does this type of lending help the economy?
To provide an example: if Sean has €100 and gives a loan of €50 to Liam. Sean can say he has €100 in assets (the €50 he has in cash & the €50 he is owed by Liam) and Liam has €50 in assets. The total is now €150. Then Liam lends €25 to his mother Brid. Liam can claim he has €50 in 50 in assets (€25 in hand and €25 owed) and his mother Brid can claim she has €25 . The total is now Sean’s €100, Liam’s €50 and his mother Brid’s €25 for a total of €175 that everybody says they “have” from the original €100. Of course it is really €100, but the key is that everybody is now acting (spending) like they have money and this drives the economy. If Liam & Brid waited until they actually had un-borrowed money to spend, the thought is that the economy would suffer from inactivity.
So how were the bankers reckless? How or why did they break one of the fundamental rules of banking when it came to “Fractional Reserving”?
Well Peter says that a look at Bank of Ireland’s (Bol) Balance Sheet at March 2008 gives an insight into the Bank’s reckless deviation from the time-tested Prudential Principle in bank balance sheet of “fractional reserving”, whereby loans to customer deposits ratio are maintained at a maximum of 90%.
But BoI’s balance sheet at March 2008 showed the loans to customer deposit ratio at an astonishingly dangerous 158%.
Peter contends that this fact alone is indisputably clear evidence of the Bank’s direct responsibility (along with all the other banks in the sector that had also abandoned the Prudential Principle of fractional reserving in their balance sheet management), as the prime cause of the growing massive credit bubble over a number of years leading to the eventual assets price collapse, particularly in the property market.
It’s quite dear from the facts that by allowing its loans to deposits ratio move away from the tested safe 90% level and climb to a dangerous level of 158% that the difference of 68% (158% vs 90%) as a proportion of the correct prudential level is an accurate measurement of the bank’s proportional culpability in being a major driver of the credit bubble (68%/90% = 75%). Accordingly, it is reasonable to argue based on the evidence that the Bank should be accountable for 75% of the collapse in prices of assets bought by customers of the bank-funded mortgages.
This is why the banks and their bond holders should have carried their share of the burden. And surely is a factor which must be considered by any future banking inquiry.
Now at this stage, more importantly we must also ensure that this can never happen again!