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The State of the Banks

The vitality of Western economies is based, in important ways, on the health of our credit system. This system depends on the actual financial strength of large Western banks, on the financial and fiscal policies of Western governments, as well as on public psychology. Today, for a variety of reasons, we are witnessing a loss of confidence in our banking system which, if allowed to continue, could have serious repercussions.

The word “credit” derives from the Latin credere: to believe. Prudence on the part of lenders and borrowers has to be supported by the general belief on the part of consumers and depositors that the system will work. Today, this belief has become perilously fragile. It is not fragile, as some bankers may believe, because “there is too much loose talk about the problem.” By now, every responsible businessman should know that the word “crisis” is newsworthy and that press and TV reporting make it utterly impossible to avoid serious questions about the banking system, even if it were desirable to do so. Furthermore, it is undeniable that both the known facts and the potential problems argue against a policy of hoping to muddle through with a little bit of luck. The risk of inaction is simply too great.

During the last decade, major changes have occurred in the organization and functioning of Western economies, world trade, and the distribution of wealth among nations. All of these changes, in one form or another, are causes for the enormous pressures that weigh on our banking system.

The first of these causes lies in the international economy. The world today appears to have entered a deflationary cycle. For the first time since World War II every industrially developed country is in various stages of recession. Unemployment levels are rising and inflation rates are coming down. Real interest rates are still prohibitively high and financial pressures are causing cutbacks in industry and government. In the US, the fight against inflation appears to be successful; we may, however, find that success carries a heavy price. The impact of US deflation on the rest of the world is staggering: recession, unemployment, and collapsing raw material prices are a worldwide phenomenon. There can be no worldwide recovery without a US recovery; the US has to be the locomotive.

Second, the demise, in 1971, of the arrangements made at Bretton Woods in 1945 caused the breakdown of an international monetary system which made the years between 1945 and 1971 among the most successful in the history of monetary management. Indeed for all countries, rich and poor, this was the most fruitful period in the history of the world. Harold Lever, who has one of the most brilliant financial minds in England, said in December 1981: “Bretton Woods was itself the greatest single achievement in terms of creating an institution which would bridge the growing interdependence of the world and national decisions.” The effect of the Bretton Woods agreements was to make the dollar the world’s reserve currency, against which every other major currency was pegged. When the Bretton Woods system broke down with the floating of the dollar in 1971, no country or group of countries was able to assume the responsibilities that had been carried by the United States; no international currency was substituted for the dollar. Bretton Woods was replaced by nothing, and the OPEC oil shock of 1973 was superimposed on a world monetary system that had been completely disrupted.

Third was the distress caused by the rise of oil prices after 1973. OPEC created huge, long-term balance-of-payments deficits in many countries of the world whose economies were shaken by high energy costs they could not pay for. Lacking an adequate monetary system, the rich and poor nations had to resort to the policy of “bank recycling.” This was a process whereby OPEC oil producers deposited their surplus cash with Western banks, which then lent the money partly to poorer non-oil-producing countries in need of credit. There was, at the time, no alternative to bank recycling other than direct OPEC lending to third-world countries, and OPEC loans to such countries remained relatively small.

However, the effect of bank recycling was to lend more and more to less-and-less-credit-worthy borrowers; it meant ever greater burdens on weak borrowers. Running as high as $100 billion per year, OPEC surpluses were deposited with Western banks which lent part of them throughout the world. No doubt both some of the banks and some of the borrowing countries were incautious and overeager in arranging these loans. By 1982 the third world’s debt reached $500 billion, most of it in the form of shortterm debt.

Fourth, during the Seventies, “détente” governed our relations with the Soviet Union and Eastern Europe. Mutual economic interests would, it was thought, help create an atmosphere in the Soviet Union which would restrain its geopolitical behavior while a step-by-step process of limiting and reducing arms could take place. Encouraged by their governments, Western banks lent Eastern Europe over $50 billion between 1972 and 1982. The collapse of both détente and the Eastern European economies abruptly halted this process.

Last but not the least important was our appetite for credit in the US itself. Growth and inflation were the dominant economic trends of the 1970s, interrupted here and there by recession in one Western country or another, but never at precisely the same time among all Western countries. The high rates of inflation sharply lowered real interest rates and permitted heavy borrowers to “service” their debts—i.e., pay both interest and installments of the principal—with cheaper currency. The conviction grew among many business leaders, especially in the US, that inflation was here to stay. As a result, the use of credit soared. In 1950, the average US corporation had $43 of operating income to meet each dollar of interest payments; today, the average corporation has less than $4 to meet each dollar of such payments. Liquid assets are down to 24 percent of short-term liabilities, half of what they were during the 1950s. The ratios of short-term debt to long-term debt on corporate balance sheets have climbed from 40 percent in the 1950s to 70 percent today.

Short-term debt has been used not only to provide long-term capital assets such as new plants but much else besides, including real estate and other speculations, and larger and larger corporate takeovers. Normal prudence would have required much greater use of long-term credits, but their high interest cost was often deemed prohibitive. As a result, many American corporations under heavy obligation to repay short-term loans now find themselves short of “liquidity”—cash or assets convertible into cash; and the banks, the providers of short-term credit, have become more and more “exposed”—i.e., are owed increasingly large sums in relation to their own assets.

It is dangerous to generalize. Not all banks are in trouble; not all countries pose similar credit risks. However, the interdependence of the international monetary system is such that, in some respects, the system is only as strong as its weakest links. We cannot, for instance, ignore the situation of Canadian banks. The absence of any legal lending limits, a government policy of financing Canadian repurchase of energy assets, and the collapse of the local economy—all have contributed to the dangerously overextended condition of the Canadian banking system. German banks have made large and often risky loans in Eastern Europe; Belgium’s second largest bank faces a $200 million loss with an obscure Saudi foreign-exchange trading firm. These are matters of concern to all of us even though the respective central banks have the direct responsibility as ultimate lenders.

Completely outside the system is a network of banks for which no central bank is directly responsible. The best current example of such “rogue” banks is the Italian Banco Ambrosiano in which the Vatican is reported to have lost over $1 billion and whose Luxemburg subsidiary owes Western banks over $400 million. Nobody really knows the size of the outstanding loans of banks in such tax-shelter havens as the Cayman Islands. It could be significant.

When New York City faced its crisis, some argued against full disclosure of the magnitude of the city’s problems, above all its inability to borrow more money in view of widespread skepticism about its ability to pay. It was argued, not without some justification, that disclosure would bring on the very crisis the city was trying to prevent. Those of us who were asked to help the city chose to disclose the facts while at the same time coming forth with a plan to resolve the crisis. It was a correct, if probably inevitable, decision. The same must now be done on a much vaster, more complicated scale.

The unknown in many ways is scarier than the known. Rumors about the shaky condition of this or that bank are creating financing difficulties for some American banks, notwithstanding the widely shared judgment that the Federal Reserve would never permit a major American bank to default on its obligation to depositors. It is imperative that steps be taken, rapidly, to restore confidence in the banking system, both domestically and internationally.

The steps outlined here are not necessarily a “solution” to the problem: there may be no solution short of a decade of strong, worldwide economic growth. They are, rather, intended to suggest a coordinated process that would shore up the system and avoid a crisis. Several discrete issues will have to be faced very soon if, during the next three to five years, we are to avoid a financial breakdown.

1) The US banking system must be strengthened. According to the Federal Reserve, as of May 1982 US banks have lent over $300 billion abroad. This includes $200 billion in Latin America, the third world, and Eastern Europe. To put these numbers in perspective, it is worth noting that the total equity of the thirty largest US bank holding companies as of mid-1982—i.e., the value of their assets above their total liabilites—was about $40 billion. American banks are major participants in Mexico’s $80 billion of external debt, as well as Brazil’s $60 billion and Argentina’s $40 billion. The risks to American banks of an unexpected default by these and other countries would therefore be grave ones.

Complicating the situation are certain illusions and accounting practices that shape many banking decisions. It is, in my judgment, an illusion to think that no sovereign country will default on its external debt because it would become a pariah in the international financial community. Default or a repudiation of debt could occur as a result of radical political changes (as is possible in literally any Latin American country) or geopolitical decisions (as might be the case in Eastern Europe).

At the same time, the prevailing accounting practices show more than a few banks making higher operating profits by “rolling over,” or extending, highly questionable debts from borrowers like Poland, thereby avoiding writing them off as a loss. This practice creates a dangerous illusion. A bank’s operating results appear to be improved as it takes on greater and greater debts from risky countries, and the bank becomes more and more the prisoner of the borrower.

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