The modern banking system – the essential enabler of saving, investment, payment and exchange which provides the crucial blood flow of credit through the body of the modern economy – is a magnificent illusion.
Politicians and commentators who debate banking and slip into pronouncements about "moral hazard" or "burning bond-holders" rarely seem to consider its frightening fragility. While there may be some sense that modern banking involves a little more than the smooth recycling of savings into loans, there seems to be little consideration of how, at heart, it's a system of largely unthinking trust.
Loans are just promises with greater or lesser likelihoods of being honoured. Deposits are mostly just claims on those promises. In effect, a stock of promises to repay has been made to banks by borrowers, banks that, in turn, have used those promises (assets) to secure a stock of claims (liabilities) held by depositors or bond-holders. Into this trust-dependent system is added the Janus-faced approach of promising depositors access to their 'money' on demand, having lent most of this 'money' to business-owners or house-buyers from whom repayment will not be sought for many years.
To get a better sense of how these two potentially contradictory but generally sustainable commitments are made by the modern bank, imagine borrowing money that you have committed to repay to a depositor on demand and, at the same time, lending most of it to someone from whom you will not seek repayment for 20 years or more. This is the tightrope being walked hourly by the modern banking system.
Finally, ponder the key implication of this overall system: only a fraction of depositors' 'money' can actually be made available on demand – the rest is merely a claim on a promise. The successful blurring of this reality with the simultaneous provision of long-term credit arguably underpins the modern economy and clearly depends on the trust of those who hold the claims to the promises. Lose that trust and the system unravels.
This illusion has enabled the development of a modern world of generally rising prosperity which, if shattered, would risk a chaotic return to a more brutish past.
How much food and fuel does the typical urban-dweller store? How much economic activity would survive a breakdown in exchange? How would countries that import food and energy secure supplies? How would society support the weak in such a breakdown? These are just some of the questions that arise from any consideration of the consequences of the collapse of a modern banking system.
In the midst of continued deposit flight and intensifying debate about how taxpayers can be relieved somewhat of liabilities of the banks, let's reflect a little on the situation.
Pieced together from the latest published accounts, Central Bank releases and some reasonable approximations from anecdotal evidence, the table shows the likely current picture of outstanding claims on domestic banks.
It should be clear from the foregoing description of the magnificent illusion of the banking system that maintaining the trust of these claimants should be the primary goal. Sensible policy should now seek to avoid being squeezed between the rock of deposit flight and the hard place of more reliance on the ECB. In the same vein, any moral refreshment from rebuking the claims of senior bond-holders, for example, might prove short-lived, if their fellow depositor claimants are prompted to accelerate their rush for the door.
Policy-making with a grasp of history has seldom seemed as important. Though the antecedents of this system can be traced to the goldsmiths of medieval Europe, the true conjuror of modern banking was probably US president Franklin Roosevelt. His pledge of the full authority of the government restored trust to a banking system paralysed by fear. Deposits, now insured by the government, returned, and through the illusion of modern banking, helped propel the US economy down a multi-decade path of expansion.
Do we really want to risk sundering this magnificent illusion for ourselves and others?
John Looby is an investment manager at Setanta Asset Management
Domestic bank liabilities
ECB and Irish CB €130bn
Senior debt €72bn
Subordinate debt €13bn