[R-G] [BillTottenWeblog] Credit Where Credit Is Due

[Bill Totten]

The Direct Way to Fix the Credit Crisis

by Ellen Brown

www.webofdebt.com (January 11 2009)


Letter to the bank -

Dear Sirs, In light of recent developments, when you returned my check
marked "insufficient funds", were you referring to my funds or yours?

Economist John Kenneth Galbraith famously said, "The process by which
banks create money is so simple that the mind is repelled".  If banks
can create money, why are we suffering from a "credit crunch"? Why can't
banks create all the money they can find borrowers for? Last fall,
Congress committed an unprecedented $700 billion in taxpayer money to
reversing the credit crisis, and the Federal Reserve has already fanned
that into $8.5 trillion in loans and commitments. {1}  But the bank
bailout has proven to be no more than a boondoggle for a handful of
lucky Wall Street banks, without getting credit flowing again.

To understand the real cause of the credit crisis and how it can be
reversed, we first need to understand credit itself - what it is, where
it comes from, and what the real tourniquet is that has limited its
flow. Banks actually create credit; and if private banks can do it, so
could public banks or public treasuries. The crisis is not one of
"liquidity" but of "solvency". It has been caused, not by the banks'
inability to get credit (something they can create with accounting
entries), but by their inability to meet the capital requirement imposed
by the Bank for International Settlements, the private foreign head of
the international banking system. That inability, in turn, has been
caused by the derivatives virus; and only a few big banks are seriously
infected with it. By bailing out these big banks, the government is
actually spreading the virus by furnishing the funds for them to take
over smaller regional banks.

A more effective alternative than trying to patch up the hopelessly
imperiled derivatives positions of these few Wall Street banks would be
to simply create another credit system with a pristine set of books. We
don't need to fix the Wall Street disease; we can bypass the whole
problem and create a new, healthy, parallel system. A network of public
banks (federal and state) could create "credit" just as private banks do
now. This credit could be extended at low interest rates to consumers
and at very low interest to local governments, drastically reducing the
cost of public projects by reducing the cost of funding them.

That is not a radical proposal.  It is what private banks themselves do
every day. But bankers will dispute it, and most people have trouble
believing it. So to make a compelling case for this solution, the first
thing that needs to be established is that ...

Banks Create the Money They Lend

Bankers will tell you that they do not create money. At a ten percent
reserve requirement, they simply lend out ninety percent of their
deposits. The catch is that their "deposits" include the money they have
written into their customers' accounts as loans. That is how loans are
made: numbers are simply written into the accounts of borrowers, as many
reputable authorities have attested. Here are two of them, dating back
to when officials were either more aware of what was going on or more
open about it:

"[W]hen a bank makes a loan, it simply adds to the borrower's deposit
account in the bank by the amount of the loan. The money is not taken
from anyone else's deposit; it was not previously paid in to the bank by
anyone. It's new money, created by the bank for the use of the borrower."
--- Robert B Anderson, Treasury Secretary under Eisenhower, in an
interview reported in the August 31 1959 issue of US News and World Report

"Do private banks issue money today? Yes. Although banks no longer have
the right to issue bank notes, they can create money in the form of bank
deposits when they lend money to businesses, or buy securities ... The
important thing to remember is that when banks lend money they don't
necessarily take it from anyone else to lend. Thus they 'create' it".

--- Congressman Wright Patman, Money Facts (House Committee on Banking
and Currency, 1964)


The process by which banks create money was detailed in a revealing
booklet put out by the Chicago Federal Reserve titled Modern Money
Mechanics {2}. The booklet was periodically revised until 1992, when it
had reached fifty pages long. It is written in somewhat difficult prose,
but here are a few relevant passages:

"The actual process of money creation takes place primarily in banks".
[page 3]

Translation: banks create money.

"In the absence of legal reserve requirements, banks can build up
deposits by increasing loans and investments so long as they keep enough
currency on hand to redeem whatever amounts the holders of deposits want
to convert into currency". [page 3]

Translation: banks can create as much money as they want by writing
loans into their borrowers' accounts, limited only by (a) legal reserve
requirements (money that must be held in reserve - traditionally about
ten percent of outstanding deposits and loans) or (b) the amount of
money they will need to keep on hand to pay any depositors who might
come for their money (also traditionally about ten percent).

"Banks may increase the balances in their reserve accounts by depositing
checks and proceeds from electronic funds transfers as well as
currency". [page 4]

Translation: the "reserves" that count toward the reserve requirement
include currency, deposited checks, and electronic funds transfers.
(Note that the "deposits" created as loans are excluded from this list
of allowable reserves: the bank cannot just keep bootstrapping loans on
top of loans but must have money from external sources backing up its
liabilities equal to about ten percent of its loans and deposits.)

"The money-creation process takes place principally through transaction
accounts [accounts that can be drawn on without restriction]". [page 2]

"With a uniform ten percent reserve requirement, a $1 increase in
reserves would support $10 of additional transaction accounts". [page 49]

Translation: $1 deposited by a customer can be fanned into $10 in loans.

"In the real world, a bank's lending is not normally constrained by the
amount of excess reserves it has at any given moment. Rather, loans are
made, or not made, depending on the bank's credit policies and its
expectations about its ability to obtain the funds necessary to pay its
customers' checks and maintain required reserves in a timely fashion."

Translation: In practice, banks issue loans without worrying too much
about whether they have the reserves to cover them. If they come up
short, they can just borrow them:

"[Since] the individual bank does not know today precisely what its
reserve position will be at the time the proceeds of today's loans are
paid out ... many banks turn to the money market - borrowing funds to
cover deficits or lending temporary surpluses". [page 50]

"[A] bank may [also] borrow reserves temporarily from its Reserve Bank ...

[However], banks are discouraged from borrowing [Reserve Bank]
adjustment credit too frequently or for extended time periods". [page 29]

Translation: If the bank finds at the end of the accounting period that
its reserves do not come to the required ten percent of its outstanding
loans and deposits, it can simply borrow the reserves it needs from the
money market or its Federal Reserve Bank.

A 2002 article posted on the website of the Federal Reserve Bank of New
York noted that today, few banks are constrained by reserve requirements
at all:

"Since the beginning of the last decade, required reserve balances have
fallen dramatically. The decline stems in part from regulatory action:
the Federal Reserve eliminated reserve requirements on large time
deposits in 1990 and lowered the requirements on transaction accounts in
1992. But a far more important source of the decline in required
reserves has been the growth of sweep accounts. In the most common form
of sweeping, funds in bank customers' retail checking accounts are
shifted overnight into savings accounts exempt from reserve requirements
and then returned to customers' checking accounts the next business day.
Largely as a result of this practice, today only thirty percent of banks
are bound by a reserve balance requirement." {3}

Even without official reserve requirements, however, banks must keep
enough money on hand to meet withdrawals or checks written against the
accounts of their depositors; and that generally means about ten percent
of outstanding deposits and loans, as moneylenders discovered centuries
ago. But if the banks come up short, they can borrow this money from the
money market or the Federal Reserve; and if the Fed comes up short, it
can create new reserves {4}.  So why the current credit crunch? What is
limiting bank lending?

One answer is that borrowers are simply "tapped out" and not in a
position to take out as many loans as they used to. When housing and the
stock market crashed, consumers no longer had home or stock equity to
borrow against. {5} But to the extent that the blockage is with the
banks themselves, it is not caused by the reserve requirement. Something
else is putting the squeeze on credit ...


The Real Tourniquet:
Capital Adequacy and the Mark-to-Market Rule

What actually constrains bank lending is the capital adequacy
requirement, something that is imposed not by our own central bank but
by the Bank for International Settlements (BIS). Called "the central
bankers' central bank", the BIS pulls the strings of the private
international banking system from Basel, Switzerland.

How the capital requirement is determined is even more complicated than
the reserve requirement, but it needs to be understood to understand why
banks with the power to create money are going bankrupt. So here is a
simplified version. A bank's "capital" consists of its assets minus its
liabilities. Under the capital adequacy rule imposed by the Basel
Accords, assets are "risk-weighted", with some being considered riskier
than others. Ordinary loans have a "risk weighting" of One. The capital
adequacy rule requires that the ratio of a bank's capital to its assets
with a risk-weighting of One be at least eight percent. That means the
bank must have $8 in capital for every $100 in ordinary loans. Federal
bonds have a risk-weighting of zero: they are considered to be as safe
as dollars and don't need any extra capital backing them. Mortgage loans
(which are secured by real estate) have a risk weighting of 0.5. That
means they need only $4 of capital per $100 of loans. Other bank
exposures given risk weightings include such things as derivatives and
foreign exchange contracts. {6} (Interestingly, the $700 billion
committed by Congress to bailing out the financial system is
approximately eight percent of the $8.5 trillion the Fed has now
promised in loans and commitments. Even the Federal Reserve evidently
feels constrained by the BIS capital requirement.)

A very controversial accounting rule imposed on banks for their capital
ratio calculations is the "mark to market" rule. This rule requires
banks to revalue all of their assets each day as if the assets had to be
sold that day. Capital calculations thus fluctuate with the market; and
in today's volatile market, all asset classes have plunged at the same
time. Since assets get marked to market but liabilities don't, a bank
may suddenly find that its assets are insufficient to support its
liabilities, rendering it insolvent and unable to make new loans. Banks
have gotten around the capital adequacy requirement by reducing risk on
their balance sheets with a form of private bet known as "derivatives".
At least, they thought they had gotten around the rule. But this
unregulated form of insurance proved to be based on faulty mathematical
models. (See Ellen Brown, ""Credit Default Swaps: Derivative Disaster Du
Jour", and "It's the Derivatives, Stupid!", www.webofdebt.com/articles.)

"Credit default swaps" (CDS) are a form of derivative widely sold as
insurance against default. When AIG, the world's largest insurance
company, ventured into CDS in the late 1990s, the presumption was that
"housing always goes up" and that the risk of default was so remote that
selling "credit protection" was virtually "free money" {7}. But this
free money turned into a serious liability to the protection sellers
when the "remote" actually happened and a flood of defaults struck. The
value of the derivatives protecting securitized mortgages became so
questionable that they were unmarketable at any price. Banks counting
them as assets on their books then had to "mark them to market"
effectively at zero, reducing the banks' capital below the levels called
for in the Basel Accords and rendering the banks officially insolvent.

When AIG went broke in September 2008, banks heavily involved in
derivatives faced double jeopardy: not only would they have to write
down the derivative protection they had sold to others and counted as
assets on their books, but they could no longer count on the derivative
insurance they had bought to minimize the risk of default on their other
assets. AIG got a massive bailout from the Fed in return for most of its
equity, but even that bailout money is not expected to be enough to get
it out of its derivative nightmare and keep it afloat.

Derivatives have introduced a lack of transparency into bank portfolios,
creating fear and uncertainty on the part of lenders, depositors and
investors alike. This uncertainty has prevented banks from raising
capital by selling stock, or meeting reserve requirements by getting
interbank loans; and it has discouraged investors from investing in the
money market. Banks don't know whether the money they lend to each other
will be repaid, since they don't have a clear view of the value of the
assets carried on bank balance sheets. The result is a crisis of
confidence: the players are all eying each other suspiciously and
holding their cards close to the chest.


Going Local

Fortunately, according to a recent study using the Treasury Department's
own data, the banking crisis is not widespread but is limited to only "a
few big, vocal banks" {8}.  The real credit problem lies with the
financial institutions with significant derivative exposure, and most of
this liability is carried by only a handful of Wall Street giants. In
early 2008, outstanding derivatives on the books of US banks exceeded
$180 trillion. However, $90 trillion of this was carried on the books of
JPMorgan Chase alone, while Citibank and Bank of America each had $38
trillion on their books. {9] Needless to say, these are also the banks
that are first in line for the Treasury's bailout money under the
Troubled Asset Relief Program. Rather than excising the relatively
contained derivative tumor, the Treasury and the Fed are feeding it with
trillions in taxpayer money; and this money is being used, not to
unfreeze credit by making loans, but to buy up smaller banks. {10}  That
means the derivative cancer, rather than being excised, is liable to spread.

We the people and our representatives in Congress have allowed Wall
Street to call the shots because we think we are dependent on their
credit system, but we aren't. There are other ways to get credit - ways
that are fair, efficient, transparent, and don't encourage greed. Public
credit could be generated by a system of public banks. Precedent for
this solution is to be found in the state-owned Bank of North Dakota,
which has been generating credit for North Dakota since 1919, keeping
the state fiscally sound when other states are floundering. (See Ellen
Brown, "Sustainable Government: Banking for a 'New' New Deal",
webofdebt.com/articles, December 08 2008.)

The credit crunch could be avoided by "going local" not just in the
United States but around the world. Countries that have been seduced or
coerced into funneling their productive assets into serving foreign
markets and foreign investors could become self-sustaining, using their
own credit and their own resources to feed and serve their own people.
There is much more to be said on this subject, but it will be saved for
future articles. Stay tuned.

Notes:

1. Kathleen Pender, "Government Bailout Hits $8.5 Trillion", San
Francisco Chronicle (November 26 2008).

2. Modern Money Mechanics: A Workbook on Bank Reserves and Deposit
Expansion (Federal Reserve Bank of Chicago, Public Information Service,
1992, available at
http://www.rayservers.com/images/ModernMoneyMechanics.pdf.

3. Paul Bennett, Savros Peristiani, "Are Reserve Requirements Still
Binding?", Economic Policy Review (May 2002).

4. Modern Money Mechanics, op cit.

5. Joshua Holland, "Was the 'Credit Crunch' a Myth Used to Sell a
Trillion-Dollar Scam?", AlterNet (December 29 2008).

6. "Capital Requirement", Wikipedia.

7. Robert O'Harrow Jr, Brady Dennis, "Complex Deals Led to AIG's
Undoing", Los Angeles Times (January 01 2009).

8. Joshua Holland, op cit.

9. Comptroller of the Currency, "OCC's Quarterly Report on Bank Trading
and Derivatives Activities Third Quarter 2008", www.occ.treas.gov; "US
Bank Derivative Exposure", FDIC/IRA Bank Monitor, chart reproduced on
The Big Picture (blog), August 2008.

10. Joe Nocera, "So When Will Banks Give Loans?", New York Times
(October 25 2008).

_____

Ellen Brown developed her research skills as an attorney practicing
civil litigation in Los Angeles. In Web of Debt (2007), her latest book,
she turns those skills to an analysis of the Federal Reserve and "the
money trust". She shows how this private cartel has usurped the power to
create money from the people themselves, and how we the people can get
it back. Her earlier books focused on the pharmaceutical cartel that
gets its power from "the money trust". Her eleven books include
Forbidden Medicine (2008), Nature's Pharmacy (1998), co-authored with Dr
Lynne Walker, and The Key to Ultimate Health (2000), co-authored with Dr
Richard Hansen) Her websites are www.webofdebt.com and www.ellenbrown.com.

Copyright (c) 2007 Ellen Brown. All Rights Reserved.

http://www.webofdebt.com/articles/creditcrunch.php


TO POST A COMMENT, OR TO READ COMMENTS POSTED BY OTHERS, please click
on the word "comment" highlighted at the end of the version of this
essay posted at http://billtotten.blogspot.com/