Mistrust (1)

A common saying is that the financial system is based on trust. Many economists suggest that trust disappeared at the end of 2007 and the system ground to a halt. For example, depositors queued outside Northern Rock to withdraw their deposits, because they no longer trusted the bank.

The view that the finance system is based on trust is wrong. A sound financial system should be based on mistrust. We know that some people are dishonest, some are greedy and anyone can be tempted if the right opportunity arises. We also not that people can get into financial difficulty, despite there best intentions. These factors mean that lending money to another person can be very risky.

Originally people would only lend to people they trusted because they knew them really well. That is the original meaning of the word credit. A person would be given credit, because their character was known to be creditworthy.

Limiting lending to family and friends can be quite restricting for the development of an economy, so investors started looking for ways to expand the scope of lending. The banking system emerged as a way of reducing or managing the risks of lending to people who would not normally be trusted, because they were not well known.

A whole range of practices were introduced to prevent borrowers from defaulting or absconding without repaying their loans: letters of credit, documentation, credit checks, sets of accounts, guarantees, collected, liens, mortgages and repayment insurance. These institutions have two purposes. They identify people who should not be trusted and so lenders do not make loans to them. They also ensure that if a borrower defaults on a loan, the lender has sufficient security to get back most of what they lent.

This system works well when banks do their job. The bank’s role is to identify potential borrowers who can afford to repay their loans and who will be willing to repay when any loan when its term is complete. The bank will also endeavour to hold sufficient security to ensure that that they can recover the loan, if the borrower defaults.

The bank’s role is based on the principle that borrowers cannot always be trusted, so processes are put in place to ensure that borrowers are unable to abscond without repaying their loans. They act as intermediaries to assist savers to lend to people they would not usually trust.

Bailment (2)

If a deposit in a cheque account is a bailment, then the bank could not record the cash as an asset on its balance sheet. It could not use the cash for its own purposes.

During the 19th century, the British Law Lords ruled that a demand deposit is not a bailment. This decision has since between adopted by courts all over the world.

In a case in 1811, Sir William Grant ruled that money paid into a bank is not a bailment, but a loan. The banker is not a bailee, but a debtor (Carr v Carr). In a subsequent case, he said, “The money paid into a banker immediately becomes a part of his general assets and he is merely a creditor for the amount" (Devayne v Noble).

Lord Cottenham summed up the early decisions in Foley v. Hill and Others.

Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it . . . . The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal....

According to modern law, a bank deposit is not a bailment, so the bank is entitled to record the deposit as an asset on its balance sheet.

I doubt that this is understood by most bank depositors.

Wide Boy Bankers

I was amused by Rodger Bootle's comments in the Telegraph

Not long ago, banks and other lenders were falling over themselves to lend on wafer-thin margins to people and propositions which their predecessors would not have touched with a bargepole: 125 per cent mortgages; huge multiples of earnings; self-certification. Now the lenders are shutting up shop and fancy mortgages have disappeared like melting snow. Both approaches cannot be right.

The silence about the corporate behaviour which led us to this pretty pass is scandalous. Come off it boys, you were sucked into a bubble of the classic sort. You were persuaded to believe that nothing could go wrong. Yet any study of financial history would have set the alarm bells ringing. But do you ever read any? To his great credit, the Governor of the Bank of England warned explicitly and publicly of the risks. But did you listen? Outside commentators and analysts, and even, in some cases, your own in-house experts, pointed out the over-valuation of property. But did you pay any attention?

The Long Put

The economic journalists are getting stirred up about the huge bonuses paid to ultra rich bankers. Their concern is that by the time the consequences of the bankers trading come home to roost, the bonuses are well spent.

I am not too worried about the bankers. There is one contingency that they have not built into their computer models. They will have to give an account to God for what they do with their money.

The Parable of the shrewd manager (Luke 16:1-12) is not easy to interpret, but one thing is clear. We will accountable to God for what we do with our material wealth, not just for our spiritual gifts. Jesus adds a further challenge.

From everyone who has been given much, much will be demanded; and from the one who has been entrusted with much, much more will be asked (Luke 12:48).

The more that people have, the more that God expects of them. I am glad that I do not get a million dollar bonus, because I could not cope with the responsibility that brings.

One day the bankers and deal makers will have to stand before God and give an account of what they have done with all that they were given. All their options will be closed out. Why would anyone envy them.