Why banking is so risky

Jun 03 2015 06:55
*Edward Ingram

IN MY last essay for Fin24, I explained three major ways in which costs and prices are distorting the world’s economies.

In short, the world is full of imbalances. If the prices had adjusted naturally, would there be any major imbalances or long lasting imbalances to be worried about?

The textbooks say not.

The textbooks are right.

One of these ways is the way that houses, governments and commerce are financed. Here is an extract taken from the mathematics paper that I am writing for my book:


If the 'X' is placed anywhere on the Y-axis [of my risk management chart below] and above the standing loan line, and if the 'X' is pinned permanently to the Y-axis, it is a typical 'level payments' loan as used in South Africa and elsewhere:  e% = 0%.  

I.e. no e% p.a. escalation of the repayments is scheduled. [The horizontal axis allows the loan servicing repayments to rise or fall every year rather than standing still.] But without that X-axis being permitted by the regulators, the payments will jump up and down if the nominal rate of interest changes. This is highly dangerous. It is how things are done now: it is dangerous and disruptive to the well-being of the whole economy.


The first principle of costing and pricing as described in almost any textbook is that at the macro level all costs and prices should adjust to bring into balance the supply and the demand. This LP method (the current method used) adjusts the cost of repayments to interest rate changes, not to supply or demand. And it does not only adjust – it multiplies that adjustment many times.

This affects the accessibility (demand) for housing finance many times faster than the demand would be altered if the cost rose at the same rate, or even at a fairly similar rate to, say, rentals, food, entertainment or anything else.

This is the response tabulated for a 25-year loan:

The sensitivity also changes as interest rates rise – it becomes less and less sensitive the higher interest rates go. The greatest damage is done at low rates of interest. This is why South Africa got off lightly:

Because the rate of increase in average earnings (AEG%) p.a. tends to be low when interest rates are low, or we can say that when AEG% p.a. is low interest rates tend to be low, I decided to calculate how long it would likely take for average earnings to overcome such a leap upwards in home loan costs. The next chart is my calculation.

All figures for all three charts were obtained from my spreadsheet calculations.

This forms a part of what I have called the LOW INFLATION TRAP. This dynamic response to home loan costs and their effects on property values makes it very difficult for central banks to raise interest rates without causing a social/political/economic problem – all three at the same time.

It is not made any easier by the fact that lenders lend more and they inflate property values by doing that, as interest rates fall.

Again, this property price change is not a response which is prompted by rising demand, and when it reverses it is not a response to falling demand. It creates those price changes. Textbook writers should be astonished that the role of pricing could be so manipulated by the lending industry. It also explains why banking is so risky.

So there is every good reason to have another look at how things could be done differently. That is why my Risk Management Chart has a horizontal axis – to keep repayment costs from jumping around.

Whereas we would expect property prices to rise and fall like rentals generally do, influenced by rising demand (rising incomes being one of the most important parts of that), what Robert Shiller and Co have shown in the USA is this:

Clearly, it was after 1997-9 that low interest rates became fashionable. Thereafter the nature of economics and the behaviour of economies went out of control.

Interest rates are also a price and they should not be managed and distorted. Both the current LP home loan repayments model and the management of interest rates interfere with costing and pricing and therefore, with supply and demand.

They both create imbalances because if the price is right there will not be any long lasting, or rapidly changing (as in the housing sector), imbalances in the world’s economies.

A number of central banks have tried to raise interest rates since 2010 and then have had to retreat rapidly:

A part of the reason for this is the above table of magnified responses to the loan servicing payments. Another part is the value sensitivity of bonds where there is another pricing structure error. And another part may be the carry trade which is a part of another issue to look at: the way that currency pricing is done.

In 2004 the Bank of England also tried to raise interest rates too fast for these markets and retreated, losing control of their inflation target in the process. The interest rate sensitivity of bond values is also a pricing error. Together they block the way forward for the world’s economies.

Next week I will explain a solution. Only when that has been implemented can we look at other reforms which are needed and being promoted by my research group and others.

* Edward Ingram is a leading thinker on the world stage of  macro-economic design and has written a series of essays for Fin24.

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