Knowing and Making

Alistair Darling has announced £4bn in money from the European Investment Bank to help small firms access credit over the next four years. I wrote a few weeks ago about the economic justifications for this and those comments still stand. However, I'm surprised - and impressed - with how fast the government has moved. The money is apparently already available, through Barclays. Barclays of course is one of the banks which did not require public capital earlier this month and so, arguably, was not subject to the condition of making funds available at 2007 levels - though it has strengthened its balance sheet with additional private equity. Even before this announcement Barclays has certainly been making some credit available over the last couple of months without unusually onerous conditions. So if anything this could be a better than usual time for creditworthy businesses to raise funds. Not what you would expect given the headlines in the financial press. Could this be, paradoxic...

Imagine a simple financial system with just three institutions: A, B and C. Let's say that each has capital of $1bn, gross assets of $10bn and gross liabilities (excluding shareholder's funds) of $9bn. Half of each bank's assets are mortgages and half are interbank loans. Of the liabilities, $5bn are interbank loans and $4bn are depositors' accounts. Finally assume there's a regulatory minimum capital limit: 8% of total assets. Now imagine that A starts to offer credit insurance on the debts of B. C has lent some money to B, so it decides that it would be smart to insure it; and takes out a $5bn policy from A. As this is a competitive market, B and C soon start to offer insurance too. A buys a policy from B insuring A's lending to C, and B insures its debt to A with C. Now say there's a 10% decline in the housing market. A's gross assets are written down to $9.5bn, eliminating half of its capital base and breaching regulatory limits. This counts as a cre...