In the City
Shadow over the banks
Tony Rudd
T f the spectre of a bank crisis is not exactly 'looming, it has nevertheless become a shadowy concern which has begun to fray the nerves of quite a few bankers today. It is so much the folklore of capitalism that the collapse of the Credit Anstalt in the ear- ly Thirties was what triggered the depres- sion that the very notion of a banking col- lapse sends shivers down well-suited backs even today.
So far there have not been many banking failures in the West. The collapse of the Herstatt Bank in the early Seventies amounts to the worst post-war incident. It led to what is called the Basle convention whereby central banks take responsibility for the operations of the subsidiaries of their domestic banks operating abroad. Hence the growing concern over the ap- parent failure of the Luxembourg offshoot of the Ambrosiana Bank in Italy which has recently been in such trouble, much to the embarrassment of the Vatican. However, more recently there was the failure of a bond house in New York, the Drysdale, which had quite a nasty knock-on effect among several of the big New York banks. And then the other day we read about the failure of a real bank in the Middle West, which again is going to have quite a knock- on effect. So far, however, none of this amounts to a banking crisis. Why then should people be feeling ner- vous? For the very simple reason that many large banks seem to be going to such lengths to pretend that all is well when many think that all is not well. To put this into a prac- tical setting: when banks have debts owing to them which are unlikely to be repayable on the terms on which the loans were originally made, they would, normally, reserve against possible losses. They would write them down in their balance sheets. One of the key criteria by which a loan can be judged to be good or not is whether the borrower can pay his interest. If he can't, then the loan does not look too good. Yet quite evidently some banks these days have so many questionable loans that they don't want to make the necessary reserves because to do so would be to admit a state of affairs which might look disastrous. Quite apart from anything else, it would blow a big hole through the bank's balance sheet. So the bank lends the customers who can't pay the interest money with which to do so. In the jargon, they 'roll up' the in- terest. There is a great deal of interest being 'rolled up' in the West today, far more than many people would think. And once that process starts it barrels along at an ever faster pace, particularly when interest rates are at historically high levels. The frenetic energy of the sorcerer's apprentice is nothing to the dynamics of compound in- terest. Of course as the telephone numbers add up, they automatically become unhing- ed from reality. They carry with them the imperative that the process be not stopped. For if it is, then the roof falls in.
It takes two to get this conspiracy going: the lender and the borrower. We can see how the lenders can get hooked. For a time it's logical for the borrowers to do so too. After all it's what happens throughout most business recessions: industry can't earn enough when demand is slack unless it retrenches; when the process of retrench- ment has gone as far as it can, companies can only do one thing and that is to borrow their way through the trouble. Most cor- porate treasurers do that. It is better than giving up and, after all, experience shows that eventually the pendulum swings and things do get better. But they have to get better reasonably quickly. The longer theY don't, the worse the borrowing becomes. Eventually some companies get to the point where they can't go any further and they voluntarily throw in the towel. Alternative- ly, banks begin to spot the weak cases and put in the receivers. But the bulk of in- dustry in the West still carries on, with balance sheets both of companies and a banks deteriorating all the time.
However, it is not only in the commercial field that risks are rising. Banks have lent a great deal to countries; 'sovereign lending' they call it. The lending usually takes the form of the ownership of large chunks of Eurodollar loans made to governments in Eastern Europe, South America and all sorts of other equally unhealthy places. Now we are at the point where countries too are 'rolling up' their interest payments — not just in Poland and in Argentina either. It is becoming a widespread habit. Again the process needs to go on; anything which stops it now will trigger off real trouble. The problem in the international arena Is that just when it is vital that the flow of li- quidity is kept up to prevent widespread default, bankers are becoming cautious and anyhow the surplus liquidity is beginning to dry up. In particular the oil producers are no longer flush with funds.
A major reason why this has not become a nightmare as yet is that when the chips are down (meaning that if there ever were a series of large bank failures) the central banks of the world would step in and pre- vent the trouble from spreading. After all it was to act as a 'lender of last resort' that central banks were invented in the first place. Even now cynics are saying that the easing on the part of the Fed during recent weeks in their intervention in credit markets in America is due not so much to their reading of the monetary tea-leaves as to their concern about potential bank failures. We would guess that if ever they thought in Washington that there was going to be trou- ble in the banking scene, either domesticallY or internationally, Mr Volker's monetary targets would be out of the window at the opening of business the next day. It is as serious as that.
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