To understand why the financial system may collapse, we need to understand how the global banking system works. People buy assets (houses, stocks, bonds), in order to increase their wealth through either capital gains or through the income that asset will pay in exchange for parking capital there.
In simple terms, we put money at risk in the hope of increasing the value of that money.
This is not how banks work. When a bank buys something, especially a bond, it parks that bond on its balance sheet as an “asset.” It then lends money out against that asset. This in itself is not problematic, except for the fact that the financial modeling of 99% of banks base assume that sovereign bonds are “risk-free.” Put another way, these models assume that the banks will always get back 100 cents on the dollar.
Yes, despite the fact that world history is replete with examples of sovereign defaults (in the last 20 years alone there have been more than 15, including Russia, Argentina and Brazil), most banks assume that the sovereign bonds sitting on their balance sheets are risk free.
This phenomenon occurs worldwide, but since it will be Europe, not the US, that takes the system down, Summers focuses on European bank models/ capital ratios.
In conclusion, he notes that Europe’s entire €46 trillion banking system is in far worse shape than even the US investment banks were in 2008 (and this is based on their leverage ratios alone).
Historically, most depositor banks made their money on the spread between the interest rates they pay depositors and the interest they receive on the loans they make. This is why they were so highly incentivized to leverage themselves to the gills. Given that a bank’s share price and executive compensation are closely tied to its profits, you can imagine why a bank would want to leverage itself as much as possible.
Even under this traditional banking model, Europe would be at high risk of systemic collapse. However, because many large banks have shifted into trading as a means of generating profits, there’s a second, even more frightening, reason why the EU banking system will likely implode.
To read Graham Summers article: What Europe Means for You and Your Savings
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BullionBuzz is a weekly eNewsletter that offers investors a quick snapshot of must-read news pertaining to the markets and precious metals. This week: Euro: Current Course Is Leading to Disaster Continue reading
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