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Bankruptcy Is Part Of The Game

The recent events in Greece and the previous Global Financial Crisis (GFC) might have given the impression that default and bankruptcy are the fruit of some kind of misconduct or malfunction. A tightening in Regulations also suggests that this view is shared by Authorities and Regulators. Excessive salaries and bonuses to top management executives and ruthless approach to business have been blamed too. But is it the whole story?

Bankruptcy has always been there

The GFC was far from being a unique and isolated event in Economics history and bankruptcy in large institutions (leaving the small ones alone) is not as rare as people would normally think. The financial services industry knows it all and calls the problem Credit Risk: the risk of not being paid what is due. Bankruptcy may not be the only cause of that, but it usually immediately precedes or follows the event. The industry has designed methodologies, developed measures, implemented data bases and created agencies to manage the issue. And, as it always happens, one also gets rewarded for the risk that is taken – as long as it is properly evaluated. Credit risk is the oldest and most understood risk in the financial world. So ignorance of the problem and novelty of the situation cannot be called as a justification for the GFC or for default or bankruptcy.

However, default and bankruptcy have always been considered an event to be managed with statistics and probabilities because, though happening frequently, they were always considered as coming from outside the financial system: poor management, misconduct, etc. One could present examples for these causes but it could now be the case for exploring other sources: what if bankruptcy was part of the game?

Designed for bankruptcy

Which game? The money whirlpool.

In this post and this other one as well, some historical considerations are made in support of the fact that money is created out of thin air by Central Banks, and that one could not distinguish money from debt. Moreover, the practice of Fractional Reserve artificially multiplies the money.

Now, if debt creates money, repaying the debt destroys it. This would still be sustainable if interest was not required: if you are required to pay more than you were given – i.e. interest – then you need to have the money to pay for it. The fundamental point is that the money for the interest was never created and injected in the system! And, by the way, it can only be created through further debt. It should now be clear that, at some point, somewhere, someone will not repay some debt, just because this money was never created in the first place. It’s hard to say who and when but it’s easy to say that this will certainly happen!

There are reasonable grounds to sustain that bankruptcy is not an unfortunate event but a consequence (it is not clear how much undesired….): to certain extent, a flaw of the system. In other words, as it stands now, the system is designed for bankruptcy.

Can it be fixed?

At a first glance, if interest is the ultimate cause, removing it should resolve the problem.

Let’s pretend for a moment that Central or Reserve Banks don’t charge interest for the money they create (i.e. lend). This means that commercial banks can have free funding from Central or Reserve Banks. Under these circumstances, the interest paid by a customer for a loan is supposed to cover only its credit risk: more precisely, it rewards the lender for the risk he’s running of not receiving the money back. If, for example, in a portfolio of ten identical loans, one of them will not be repaid at all, charging a 10% interest on each loan will ensure that, on average, the creditor will have all the money back.

Would this be enough? Well, one should expects a decreased amount bankruptcies (but there will still be some). But there are a few considerations to be made.

There is one implicit assumption in all this: the lender is expected to measure credit risk adequately at all times. One would expect this to be a fair assumption: the reality is quite different. There are some objective difficulties, sometimes, but lenders have historically failed in this….

There is also one aspect that has been (temporarily) ignored: the lender profit. Even if Central or Reserve Banks don’t charge interest, the lender will make its profit by charging a margin….

So the question remains: where is the money for interest supposed to come from?

There is a curious paradox: if the answer is that the money for interest should come from the money already created, it means that bankruptcy is there by design and that the banks are collectively responsible of the risks they try to mitigate or get rewarded of!

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