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 note that people can get into financial difficulty, despite their best intentions. These factors mean that lending money to another person can be very risky.
Credit
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 are not fully trusted, because they were no 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.
Blind Trust
During the last decade, these practices broke down and were replaced by blind trust. Many financial innovations widened the gap between lenders and borrowers to the extent the final lender knew nothing about the trustworthiness of the borrower. They had no reason for not mistrusting them, but they chose to trust.
Mortgage brokers stopped scrutinising potential borrows and started trusting anyone who asked for a housing loan.
Credit rating agencies stopped scrutinising financial institutions and started taking payments for helping them to cook up their crazy financial concoctions.
Banks lent money without knowing whether the borrower was creditworthy and with no certainty about the collateral.
Hedge funds and pension funds purchased securitised mortgages without any idea whether they would be repaid or not. The just trusted the investment banks that issued the securities.
Many of these securities have proved to be unworthy of trust, which is just what you would expect.
The credit crisis emerged because mistrust disappeared to be replaced with blind trust.
Increased regulation is not the answer. Regulation cannot make dishonest people honest and greedy people generous. Regulators cannot eliminate temptation and they cannot eliminate the risk of default. Regulations make the situation worse, because they encourage people to trust regulated activities, when it would be better for them to mistrust them.
Solution is Mistrust
The only solution is to go back to mistrust. Lenders must recognise that some borrowers will be unwilling or unable to repay their loans. Banks need to get back to doing all the things that they did in the past when dealing with borrowers that are not completely trusted. Credit checks, guarantees, collateral mortgages allow savers to lend to people they mistrust, by managing the risk of default.
When savers go back to mistrusting banks, they will start monitoring their activities and looking for banks that are running less risk. Savers should follow the example of the people who queued outside Northern Rock, because they had heard that the managers of the bank had been engaging in risky practices. We need more of this behaviour.
If I have ten gold coins, who would I trust to look after them? I would trust my wife, my adult children, a few of my friends, some of the members of my church, but that is about it. Gold coins can be melted, so proving ownership is very difficult. If I am going to give them to anyone else to look after, I would be wise to approach them with an attitude of mistrust. Only a fool would lend would blindly pass their coins on to anyone else to look after without putting in place a process to ensure that they will get them back. We should approach banks in the same way.
People who mistrust banks will look for banks which will look after their money without shifting it onto the bank's balance sheet and treating the depositor's money as if it was their own. More mistrust is the key to a more stable financial system.
Good Banks
The powerful governments of the world are talking about starting a "bad bank". Their idea is that other banks would sell all their toxic assets to the bad bank, where they could be isolated. The other banks could then get on with being normal banks.
This is a very expensive solution as the government will become responsible for all the losses on the toxic assets.
We do not need another bad bank. There are already plenty of them. What we really need is a good bank. I hope that a private business will take the opportunity presented by the current uncertain situation to establish a good bank.
We need a bank that does not claim money entrusted to it belong to it; that does not record deposits as assets of the bank.
We need a bank that does not take money that belongs to one person and loan it to another without permission.
We need a bank that does not rely on mathematical models or commission agents to make decisions about lending, but trusts relationship with borrowers and knowledge of their character.
We need a bank that does not chase profits from shonky speculations or random risk-taking.
I have described how a good bank would function in Bank Deposits and Loans.
If a good bank started, depositors would move their money to it. Other good banks would start when they saw how well the good bank was doing. Good banks would spring up everywhere, as depositors look for a safe haven. The world would see a dramatic shift of money from the existing banks to the good banks.
The true nature of our existing banks would be revealed. They would be left holding their toxic assets and depending on funding by government bailouts. Everyone would see that they really are bad banks, and avoid them like the plague.
