Spanish banks’ fake capital.

I argued yesterday that it’s OK for a bank to lend to someone on condition they purchase shares in the bank.

Having slept on the problem (which included a nightmare involving me buying favors off politicians on behalf of Goldman Sachs, ha ha) I’ve changed my mind.  It now strikes that fake capital is not actually acceptable. Moreover, what’s wrong with it is the same as what’s wrong with the ENTIRE commercial bank system, namely that commercial / private banks have the right to print some of the money they lend out. That right amounts to a subsidy of private banks in exactly the same way as backstreet counterfeiters are effectively subsidised by the community at large. Indeed that’s what I argue in this paper (which with a few modifications is appearing in an economics journal shortly).

The standard bank “loans create deposits” trick, which is how banks create or print money is obviously not EXACTLY the same as the fake capital trick, but the flaw in both those tricks is the same. I’ll explain.

If a bank out-competes non-bank entities for shareholder funds, e.g. by offering a better return on capital, that’s a fair free market contest which the bank wins. But if the bank obtains funds by simply printing money and lending it to someone at an artificially low rate of interest, and that someone buys shares in the bank, that is not a genuine free market contest between the bank and non-bank firms: the bank obtains shareholder funds on a subsidised basis. Ergo the fake bank capital trick is unacceptable. But so too is the entire private bank system in its present form (sometimes referred to as “fractional reserve” banking).

Incidentally, the sort of people who are going to borrow from a bank with a view to buying the bank’s shares will tend to be people who don’t have much to lose should they go bankrupt: they will tend to be people with no net assets, far as I can see. I.e. if person X initially has no net assets and they borrow $Y and buy $Y of shares and the shares become worthless, then X is bust. But X had no net assets to start with, so X doesn’t lose much. On the other hand, there’s a chance the bank shares do well, in which case X cleans up. So for the Xs of this world, it’s a “heads I win, tails I don’t lose” bet. X might as well go for it.

Having said that, when Barclays printed a few billion and loaned it to Sheikh Mansour on condition he bought shares in Barclays, I assume Mansour WOULD HAVE lost out, had Barclays’s shares declined, because presumably Mansour had ample net assets. As it turned out, Mansour subsequently sold the shares and made £2.25bn profit.

But to reflect that risk, Mansour would have demanded some sort of perk from Barclays, and seems he did, and got it, to judge by Vincent Richardson’s comment after yesterday’s post on this blog. (BTW Vincent, like me, is an active Positive Money supporter in the North East of England).

And finally, assuming my above argument is correct, then defenders of the existing private bank system are in a bit of a jam: if they want to object to fake bank capital, they’ll have to admit that the entire private bank system is flawed.