Danger - Banks Ahead
Below is a MRR and PLR article in category Finance -> subcategory Credit.
Danger: Banks Ahead!
Banks are often considered among the most precarious institutions worldwide, with hundreds failing every few years. Two decades ago, the US government had to inject billions into the Savings and Loans sector to stabilize it. The infamous BCCI scandal, involving multi-billion dollar embezzlement, wiped out equity capital and deposits. Barings Bank, which survived 330 years of European turmoil, was brought down by speculative actions of a rogue trader. The banking sector has witnessed over 30 major crises this century alone.
Given the high-risk nature of banking, numerous regulatory bodies oversee and insure these institutions. In the US, organizations like the FDIC cover deposits up to $100,000, while others regulate and audit banks to ensure stability.
The term "bank" comes from "banca," an old Italian word meaning bench or counter, reflecting how Italian bankers conducted business. Despite their seemingly solid marble facades, banks often hide fragility. Even President Andrew Jackson dismantled the nascent Second Bank of the United States due to a distrust of banks.
Recent scandals across Eastern and Central Europe highlight systemic issues, particularly in Macedonia. These crises often stem from a lack of trust and adverse psychological factors. Financial markets run on emotions?"fear and greed?"instead of rationality.
Banks function through credit multipliers. When Depositor A places $100,000 in Bank A, the bank reserves 20% as a liquidity cushion, assuming not all depositors will demand their money simultaneously. The remaining 80% is lent to Borrower B, who pays interest. Borrower B might deposit this money in another bank, continuing the cycle. This process, known as credit multiplication, can expand $100,000 into $900,000 theoretically, making banks heavily leveraged.
Despite their importance, banks often appear to lose money due to limited profit margins. The spread?"the difference between interest paid to depositors and charged to borrowers?"covers operational costs and leaves minimal profit. In Macedonia, this spread is 8-10%.
Interest rates, sometimes viewed negatively as usury, originally compensated for four risks: operational costs, inflation, money scarcity, and default. To maintain profits amidst these risks, banks pay minimal interest to depositors while charging borrowers as much as possible.
Complicating matters, interest rates are dictated by monetary policy rather than individual banks. Central banks adjust rates to control money supply and influence economic activity. High rates, while aiming to curb inflation, can paradoxically contribute to it by raising costs and increasing currency conversions.
In Macedonia, high default rates force banks to demand higher interest, yet this exacerbates repayment difficulties, often leading to defaults. Consequently, high rates may increase rather than mitigate default risks.
Should banks individually set interest rates or even print their own money? With the rise of electronic banking, such changes might occur without state intervention.
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