Transcript | 5. lecture: Banks are Behind it All - University for modern Slovakia

Perhaps everyone noticed that banks are always in the epicentre of every crisis. It was no different during the last global financial and economic crisis, and it is not a coincidence that the reputation of banks and bankers is at the all time low after the crisis. No wonder, people see it like this - banks and bankers caused the crisis and earn a lot of money prior to it, now when the problem arose, the states, i.e. we, the taxpayers, must save them. In other words, bankers (owners and managers) took profits and revenues and taxpayers will pay for the costs. People are rightly angry and rightly consider such privatization of profits and nationalization of losses to be unacceptable. This naturally leads to a low trust of market economy in the eyes of the people. They rightly ask why it is so.

Lovers of conspiracy theories then, based on this reality, argue that politicians are not the ones that are governing the world, but a handful of bankers who control the politicians. That is why the politicians always save bankers from any problem. However, the reality is otherwise. Even though it is true that politicians became hostage to the banks, particularly to large banks, it is not due to conspiracy or corruption, it is due to the fact that banks do not only handle their own money, but mainly money from other sources. Capital adequacy ratio is about 10%, which means that if a bank goes bankrupt, the owners lose their capital, but following consequences are much greater than the owners' losses.

Depositors will lose their money, but what is worse, the panic will spread to the whole economy due to the interconnectedness of financial markets. The larger the bank is, the larger the problem is and the faster it expands across the borders and worldwide. The phrase 'Too big to fail' applies to the situation. The story of Lehman Brothers is really a very clear evidence of it. The Greece's bailout deal from the member states of the Euro zone is substantially more about the banks than about Greece itself.

Let us have a look at how did we get into this situation, in which politicians became hostage to large banks. Today's banks evolved from goldsmiths' workshops. Gold turned into a common currency and was stored at goldsmiths, since they had safe vaults and were able to evaluate the authenticity and determine the weight of the gold. Jewellers and goldsmiths issued banknotes to the depositors and it was more convenient and safe to pay with those banknotes that to carry gold around. This is how paper money was created. Important is that these banknotes were always convertible into gold, which is defined as the gold standard.

After a while, however, the goldsmiths - bankers realized that a situation, where every depositor would come to collect the money at the same time, never occurs, and so they started to lend some portion of the gold stored at them at interest to other interested parties. They kept doing that despite that it was later made illegal and deemed as a crime. The point is that they released more banknotes to the circulation than there was gold stored at vaults.

It is clear that this was a source of enormous increase of wealth for bankers, who turn this money into political influence that helped them to enforce laws to legalize this money-lending practice. This is how the today's fractional reserve banking system evolved. This banking, however, inevitably led to the collapse of banks and it is clear that not only banks that provided bad loans and whose loans were not repaid got into problems. In the fractional reserve banking system, even healthy banks with prudent lending get into problems if too many depositors come to collect their money at the same time. The bank does not have the money; it only keeps a small reserve from its total obligations. A collapse of one bank creates a panic and depositors start to collect their money from other banks, which leads to a chain of bankruptcies of banks.

And it is exactly what happened. Excessive printing of flat money led to a boom, which sooner or later always resulted in a crisis. The largest U.S. crises occurred in 1819, 1937, 1857, 1873 and 1907. Even then there were opinions that it is the possibility of generating artificial credit through the mechanism of partial reserves that causes these crisis, however, governments were looking for solutions elsewhere. In 1863 and 1864, a central banking system was established, which created central banks located in various U.S. states. New regulation was introduced on capital adequacy, reserve requirements, prudential requirements in terms of risk regulation, as well as voluntary joining of banks in order to guarantee a shared commitment to depositors.

The crisis in 1907, however, clearly showed that this was not enough. Banks that were taking deposits from the population were already relatively strictly regulated, and new financial institutions had appeared on the market, the so-called trust institutions. They were particularly widespread in New York and they began to accept deposits, although they were originally created for the management of assets and inheritances of rich clients. Since they were not subject to such a strict regulation as were regular banks, they were able to achieve higher returns than banks and gradually more and more deposits were moved to them. They were, however, not regulated or insured against insolvency, so when the first of these trust institutions went bankrupt, it triggered an attack of depositors against the other banks, and the problem was born.

 After this crisis and panic, the government concluded that the system of quasi-central banks is not enough and in 1913 established a single federal central bank - the FED. Its aim was to determine uniform rules on capital adequacy and prudential requirements and control their compliances. FED was the instance of last resort, providing cash to troubled banks. In addition the FED received the competence to control the monetary policy, which in other words means, to determine the value of money on the market through basic interest rates and provide money to banks.

As the Great Depression showed, even the FED failed to prevent new and further attacks on banks and banking crises. During the years 1930, 1931 and 1933, they repeated as much as ever. The response was another wave of regulations and safety measures. In 1933, Glass-Steagall Act was implemented, which led to a creation of two groups of banks - commercial that accept deposits and investment that cannot.

Strict requirements were imposed upon commercial banks that had to be complied with. At the same time, the deposits became insured in these banks and they were given the opportunity to use a credit from FED. On the other hand, investment banks were not subject to such a strict regulation, because they could not accept deposits and thus they could not become the target of an attack on bank. Although since 1933, there were several attacks on banks, which even lead to their bankruptcy; it never came into such dimensions as before. Regulation and deposit insurance prevented the spread of panic, so it seemed that the era of banking crises is over. The financial crisis from 2008 - 2009 showed what a big mistake that was.