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Does anyone know why it's important for BANKS TO LEND TO EACH OTHER?

(20 Posts)
FeelingLucky Wed 08-Oct-08 20:26:41

Just wondering as I'm trying to get my head round the banking crisis. Everything else makes sense to me apart from this bit.

dinny Wed 08-Oct-08 20:27:54

because their cash flow differs

SaintRiven Wed 08-Oct-08 20:28:42

its flummoxed me completely

dinny Wed 08-Oct-08 20:28:47

<<hopes someone more knowledgeable posts in a minute!>>

dinny Wed 08-Oct-08 20:30:27

say a bank has £1 million in deposits?

they used the £1 million to go and borrow £10 million to lend to others at a higher rate

Pollyanna Wed 08-Oct-08 20:34:00

I would like a noddy guide to this too - what would have happened if the govt hadn't bailed out the banks?

FeelingLucky Wed 08-Oct-08 20:35:00

okay .. thanks dinny, think I get it now.
if I follow you correctly.
If HBOS has £1 million from savings account, they use this as collateral (??) to borrow £10million from Barclays. They then lend this to Joe Bloggs and small companies and make money from interest charges, etc. Is this right?

But, where would Barclays get £10 million from?
Where does it start/end?

FeelingLucky Wed 08-Oct-08 20:37:28

And, if HBOS had £1million in deposits from savers, why borrow £10million from Barclays?
why not use this money to lend to Joe Bloggs, etc. and earn interest/charges?

Feel as a mother in late 30s I should know this.

whomovedmychocolate Wed 08-Oct-08 20:37:47

Okay, it's a bit complex but I'll try and explain it very simply and as it was explained to me.

Money is a concept, it doesn't really exist. The money in the economy is based on confidence - confidence is lacking at the mo, so it follows that the money is not here.

Basically banks work on the basis that they lend money to folks like you and me, plus businesses and we pay them back with interest. The money they lend is made up of the money in our current accounts and savings, plus gold and other tangible assets (property etc.) that they own AND intangible assets with variable values (stocks etc).

However in order to expand business and to maintain business they often need fluctuating amounts of capital - let's say we all go in next tuesday and apply for mortgages? The bank knows at least 70% of us will pay them back and make them money so it's worth them borrowing the capital in order to fund it. Indeed it's necessary to survive.

whomovedmychocolate Wed 08-Oct-08 20:39:36

FeelingLucky - banks do pay for borrowing from other banks, there is a servicing charge and interest charges.

Oh and in case you are interested, there is something called the International Monetary Fund whose job it is to bail out entire companies when they go titsup.com (something Iceland is about to take advantage of but we did in the 70s too so we shouldn't be so bloody smug).

FeelingLucky Wed 08-Oct-08 20:50:17

WMMC - thanks for explaining and for tips on my other thread ... you can tell I'm on a 'banking' mission tonight.

I understand everything you say but not sure it answers my real question as to why banks have to lend to each other?
I'm semi getting there if I imagine all this money as a concept - so they don't actually have the money.
So, let's say you lend me a fiver but don't physically give me a five pound note (but charge me interest), then I lend my DH and my 4 DCs £1 each (and charge them even more interest over a period of 25 years). So, you've earned some money and I've earned even more money without any money actually existing??
If this is right and I substitute me and you for banks, then I've answered my own question?

And, if this lending didn't happen no one would have any money to spend and the economy comes to a halt!

FeelingLucky Wed 08-Oct-08 21:06:00

And so, when lots of people default on repayments of loans (as they did in the USA), there is a less of a willingness to lend, money is lost/not being earned ... leading to credit crunch and loss of confidence and crisis.

Is this it?

Prufrock Wed 08-Oct-08 21:15:19

That's kind of the long term reason, but in reality banks have daily liquidity needs - the banks own traders may have bought more shares from other banks than they have sold today or lent out more money to companies than they have got back in (big companies liquidity needs change on a daily basis as well). A bank (at least one that has a proper trading arm), can only deal as it wishes to if it knows that it can borrow enough money from other banks by the end of the day to have balanced it's books. There is a whole separate dept. in investment banks that deal with just balancing the banks books by the end of day. If the bank funding dept. doesn't have confidence that it can borrow enough from other banks at end of day (and these loans are normally agreed on the spot - usual last cut off time for internal depts to get funding requests to internal finance is 1pm and last GBP payments go through at 2pm so it's a hectic hour) it will place limits on the business that it's internal dept's can do, and it's that that hampers the whole system.

whomovedmychocolate Wed 08-Oct-08 21:19:22

Feelinglucky -- umm sort of.

There are always loan defaults - about 30% of loans will never be repaid - but the big picture is that the 70% that are make money. The loss of willingness to lend - yes reduces bank profits but moreover if people are stressed about money they spend less/less money sloshing about means business doesn't grow etc.

Honestly, it's very dull and happens over and over - we are about due - it'll pass in a few years. It'll be shit in the interim but it is actually fairly normal in economical terms.

FeelingLucky Wed 08-Oct-08 22:21:54

Thank you for explaining this!
FeelingaLittleMoreEnlightened now.

SaintRiven Thu 09-Oct-08 08:06:21

so do they just make up money if it doesn't exist? Whats to stop a bank typing '10 billion' into their computer?

CoteDAzur Thu 09-Oct-08 09:13:20

Banks borrow from each other to cover their short term (liquidity) needs.

Normally, banks need to match the duration of their assets and liabilities. In fact, this is a fine art that should occupy some very clever people in each financial institution.

However, with easy money (low interest rates) in recent years, banks stopped caring about matching the duration of receivables/payables, since they could always borrow in the interbank market to cover when they are shirt if cash. When bank stopped lending each other the ones with daily cash needs started going wobbly.

That is the story, in a nutshell.

Prufrock Thu 09-Oct-08 09:46:46

All actual payment between banks have to go through "clearing" using either BACS, CHAPs or SWIFT payments. These clearing houses are reconciled at the end of teh day to ensure no-one is overdrawn.

Think of it like paypal/ebay. Ebay is the markets, paypal the inter-bank clearing system, your credit card that you use to back up your paypal account the capital markets. If paypal didn't exist, and effectively allow you to borrow easily from an your credit card -it would be so much more difficult to trade freely on E-bay because you'd have to ensure that your paypal account was completely straight at the end of every day.

FeelingLucky Thu 09-Oct-08 09:53:22

Can anyone answer the question posed on this thread please?

dinny Thu 09-Oct-08 12:13:20

FL -

Darling said on C4 News they are borrowing the money, from where he didn't elaborate (China?)

so we'll have to pay the interest on the loan too, presumably

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