Adam Smith writes that a bank’s expenses consist of, ‘keeping at all times in its coffers [enough] for answering the occasional demands of the holders of its notes, a large sum of money of which it loses the interest and secondly in the expense of replenishing those coffers as fast as they are emptied’.
DEFINING IDEA…
If it’s too good to be true, it probably is.
~ PLATITUDE
When the medium of exchange settled on money in the form of gold and silver coins it wasn’t long before banks started issuing promissory notes instead of actual coins. Banks significantly increased the amount of money in the system by substituting coins for pieces of paper with no intrinsic value. These are the bank notes we know today. Smith reminds us, however, that the banks had expenses and obligations because of this system. First, they had to actually hold the equivalent gold and silver to the promissory notes issued, thus losing them potential interest, plus they had an obligation to replenish those stocks.
Banks have obviously been incredibly good at creating money out of thin air for many hundreds of years. Since Smith’s time, government has conspired with banking to deregulate an industry, allowing ‘financial weapons of mass destruction’ such as Collateralised Debt Obligation (CDOs) and derivatives to emerge. Repacking debt and selling it on meant that the banks could profit indefinitely from interest payments.
On the other side, increasingly complex financial instruments were used to replenish money through investment, the most common and potentially lethal of those being Options. These allow you to control shares at a fraction of the cost of actually owning them. Say, for example, you buy a Call Option that gives you the right, but not the obligation to buy shares for an agreed price at a certain time in the future. The cost of doing so is limited to the cost of the options contract, but if you are correct and the shares go up beyond the agreed price then you would exercise your right to buy the shares, knowing the market value is already higher. Theoretically this means you can make a killing while minimising your risk. If, however, you were the ‘writer’ or seller of that same Call Option and didn’t already own the underlying stock, then you would have to buy the shares on the open market for a higher price than you sell them for, potentially losing millions in the process!
Smith warns of the ‘Daedalian wings of paper money’. Today, complex financial instruments move invisible money around a vast financial labyrinth in a heartbeat. And yet Smith warns that coffers, ‘empty much faster than if their business was confined within more reasonable bounds’. Clearly, bank deregulation needs to be tempered with common sense and shareholders must come second to a dependable financial system.
HERE’S AN IDEA FOR YOU…
It can be seen that having little in your coffers can be catastrophic for banking and the wider economy. The same is true of individuals. If you haven’t already done so, set up an automated savings programme where 10% of your salary is diverted to a separate savings account. Do not touch that money under any circumstances and soon it will offer you a buffer and a little peace of mind.