According to Adam Smith, people must have, ‘confidence in the fortune, probity, and prudence of a particular banker, as to believe that he is always ready to pay upon demand such as his promissory notes as are likely to be at any time presented to him’. If not, there’s serious trouble.
DEFINING IDEA…
Never invest in any idea you can’t illustrate with a crayon.
~ WARREN BUFFET, BILLIONAIRE INVESTOR
Smith recognised the crucial role that trust plays in any economic system and, as we’ve witnessed, if you remove the confidence then the economic wheels of industry seize up. The first UK scalp from the US sub-prime problem was Northern Rock. Essentially, because the banks were lending mortgages, re-packaging the debt and selling it on to third parties, there was constant circulation or ‘recapitalisation’ of money back into the banking system. But then it all changed.
As home loans started to default in the US, the ratings agencies responsible for assessing risk on these complex investments realised that they had got it wrong, sending shockwaves through the financial markets. Banks, pension funds and investment houses became aware that some of their previously assumed supersafe Triple-A rated investments were not so! As a result, the banks quietly closed their doors and stopped lending as they tried to work out their exposure.
In September 2007, unable to re-capitalise on the inter-bank lending market, Northern Rock sought emergency funding from the Bank of England and sparked a ‘run’ as worried savers withdraw £2 billion within days. It was only when the UK Government stepped in to guarantee savings that trust was restored.
Since then the financial landscape has been decimated. Financial monoliths, such as Lehman Brothers and Merrill Lynch, disappeared from Wall Street. High Street banks on both sides of the Atlantic have been partially privatised to save them from collapse. ‘Write-downs’ by banks wiped at least $318 billion from banking balance sheets. In April 2008, the International Monetary Fund (IMF) estimated the sub-prime mortgage collapse is going to cost the world economy a staggering $945 billion! Icelandic bank Landsbanki collapsed, leaving 300,000 customers wondering if they would ever see their collective £5 billion again. As Niall Ferguson wrote in his book The Ascent of Money (2008), ‘The subprime butterfly had flapped its wings and triggered a global hurricane.’
In late 2008, UK interest base rates were at a fifty-seven year low, but the London Inter Bank Offered Rates (LIBOR) was significantly higher. As a result, banks were still unwilling to lend to each other or customers, thus perpetuating the credit crunch which was pushing the economy into recession.
Smith reminds us, ‘It obliges all [banks] to be more circumspect in their conduct, and not extending their currency beyond its due proportion to their cash.’ Good advice that modern banking could do well to re-familiarise itself with.
HERE’S AN IDEA FOR YOU…
The financial crisis that started in 2007 is perhaps the result of over complication of the finance industry. Pointy-headed boffins have created complex financial instruments that few actually understand. Making shrewd investments is essential for financial prosperity, but only if you fully understand the upside and the downside. If you want to play the markets, make sure you understand them and can live with the worst-case scenario.