The Incredible Shrinking Banks

This is a pretty powerful image of the impact the credit crunch (or what ever you want to call it) is having on the world's banks.

As the picture says 'most banks have seen their value halved from a year ago due to sub prime related write downs'.

"So what", I hear you say with steepled fingers, "those banks have been making huge money while the times were good, let them take some pain now. Mwhahahaha".

It matters hugely for everyone however, due to what is called 'fractional-reserve banking'.

To explain, banks have a certain amount of money (capital, deposits, etc) that they lend out (for people to buy houses, to spend on credit cards, to businesses to operate / buy other business, to other banks, to governments, etc ad infinitum).

But the banks lend out more then they have on deposit. How do they do this? The banks rely on the fact that not everyone will call upon their deposits at the same time (if they did it would be a bank run, the most recent examples being Bear Stearns and Northern Rock) and that they therefore only need keep a portion of the deposits on reserve to meet calls on deposits. These assumptions allow the bank to lend money out more then once.

For example, if the banks must retain a 20% reserve of their deposits:

• a person deposits $100 in a bank, the banks holds $20 in reserve and lends $80 out;
• the recipient of that $80 spends or saves it and that $80 ends up back in bank accounts. The banks who receive the $80 hold $16 in reserve and lend out $64 (so from the original $100 deposit we have $144 lent out);
• the process continues, the $64 makes it way back into bank accounts, $12.80 is held in reserve and $51.20 is lent out;
• in the end, from the initial $100 deposited, the banks are able to lend out $500 (this amount depends on the reserve they are required to hold) and $100 is held in reserve throughout the banks involved. In effect $400 is created through the bank's process of lending out money.

Now what happens when the banks have to write down the value of their assets as a result of sub-prime losses? They have less money to lend, and therefore total monetary supply shrinks. This means less money can be spent on buying houses (and the housing bubble bursts), less money can be put on credit cards (and consumer spending, a big driver of the economy disappears), businesses cannot borrow money (and productive growth drops), etc. It is all round bad for the economy.

These write downs effect Australia and New Zealand too, even though the banks on the list and mostly American and European. Both Australia and particularly New Zealand rely on money from overseas to fund their spending binges, as the overseas money stops following the same effects happen; less money to spend on houses, credit cards and growth.

Note: the picture came to me third hand and was apparently given by UBS to its customers to show the impact the credit crunch is having on the banks.

Update 27 April 2008: I found this article while checking back through the last weeks links I intended to post on. If KPMG are correct, which they almost certainly are, this does not bode well for NZ (and Australia) and the consequences described above of tightening credit conditions will soon be apparent. Good luck refinancing that mortgage.