The Financial Crisis 2008 -- Part Two

What I'll attempt to do now is to illustrate how the banking system works, how they make money and where the public comes in. This is the key to understanding how the system was abused and why all investors were hurt by what transpired. Worse, this crisis has spread to non-finance industries and has made a real impact on people and their lives.

Banks are very unique animals in the business world. Their simplest functions are to collect deposits from those who have spare cash, and make loans to those who need cash. These 2 things are their basic roles in life. Taking in deposits is pretty simple and is the side of the bank that most of us are familiar with. It simply is the bank being a place where you can deposit your money in exchange for certain things -- safety, a certain interest rate, convenience (ATMs, checkbooks, other banking services).

The key to this crisis is the other function of banks -- lending.

Lending money has risks attached to it. And banks are their to spread the risk, and minimize its impact for individuals.

Think about it this way -- Suppose someone knocks on your door and asks for a loan to start a business, say a restaurant. He shows you his business plans, his marketing strategy, his floor layouts, menus, etc... If you give him the loan, then you are taking on the risk that his business might fail and you don't get your money back. So to compensate you for that risk, he gives you an interest on your loan. The riskier a proposal is, the higher the interest you must demand. But if he does fail, you lose all your money that you loaned to him. Not good.

However, if he goes to a bank, then that risk is spread across all its depositors. No one single depositor faces the sole risk of this one business failing, therefore there is greater safety for everyone involved. Of course the banks still have to do their due diligence and assess what loan applications are worth taking on. After all, it's the depositors' money that they're lending out at the end of the day!

But banks cannot just make loans indiscriminately. They are restricted and limited in the amount of loans they can make. How much loans can banks make? It's set by the central banks as a percentage of their deposits and capital. So a small bank with let's say 10 million in deposits cannot make loans going to the billions because one single failure will completely destroy the bank. We in the finance world have many terms for this -- leveraging, gearing, borrowing. It's all the same. It means using a small capital base to make larger investments.

That's why the conventional banking industry is so heavily regulated. They are a crucial cog in our modern economy and yet they are also very fragile. That's why central banks regulate them and tell them how much loans they can give out. In return, some of the deposits are insured (PDIC in the Philippines, FDIC in the USA).

This is the way the conventional banking system is supposed to work. We depositors have a place that gives us safety and convenience for our money. And people and businesses who need credit and need a loan have a place to go to that will not put any single person at great risk.

However, fairly recently, there was the rise of the so-called shadow banking system. This is a term used by this year's Nobel-prize winner of economics, Paul Krugman. He writes excellent articles on the New York Times so read it if you have time.

Anyway, this shadow banking system arose because banks started to get greedy. They realized that there was money to be made if only central banks would not regulate them so heavily. So this gave rise to the other banking system that was not bound by regulations and restrictions the same way that regular banks are.

Regular banks and the shadow banks found a mutually beneficial arrangement that lead to everyone making more money. And it worked magnificently -- for a while. To give a complete picture, it was because there was a legitimate financial and business need for the banking system to evolve. But regulations were too slow to adapt to them so this separate shadow system arose unencumbered because they did not fit the traditional definition of what banks were.

Part three will deal with how this entire system failed, how it was abused and how it has led to where we are -- government bailouts, plunging stock markets, and a real recession where new jobs are harder to come by, loans are harder to get, and everyone's investment portfolio is bloodier than the Carrie's ending.