Get of my cloud and WWW you are arguing over the same point and are both rightish in principle. This is how it works
The probelm has been that banks need to have the assets supported by at least 5% of their own money.
So lets look at some simple numbers.
Banks Capital 5 .....................Assets (loans to customers) 100
Loans to bank 95
total 100 ............................................................ 100
Now a customer defaults and 1 unit gets written off.
Banks Capital 4 ..............................................Assets 99
Loans to bank 95
Total 99 ............................................................ .....99
Now to stay within the capital adequacy limits the bank has to dispose of assets. This is where the rot sets in. The best assets have to go, and loans paid off.
Now we have to readjust as follows:
Banks Capital 4 ...................................................Assets 80
Loans to Bank 76
Total ............80.............................................. .............. 80
This called de leveraging. So big loses do impact the banks borrowing ability. If deleveraging is done well there might be a small profit but a forced sale could increase the loss and we have to delever again.
As the bank's capital decreases it ability to borrow decreases.
Hence we are in the mire we are in.
To rebuild a capital base banks can either get new money from shareholders or increase the profit they make from customers from charges and the spread between what they borrow at and what they lend at.
Last edited by chrisbl; 24th Jan 2009 at 19:04.