Anyone who tells you how trustworthy they are arouses instant suspicion. Any bank that insists it's sound probably isn't.
With today's banks the problem is even more deeply ingrained. Traditionally banks have always been based on a willing suspension of disbelief. The bank starts with a modest float – its own capital – and then accepts people's deposits. Aware that these depositors are not going to all demand their cash back at the same time the bank then lends out to someone else the money that has been entrusted to it, keeping back just enough to deal with the pattern of withdrawal.
This "miracle of credit" used to allow banks to lend out ten times the amount in their liquid reserves. But in recent years a 1 to 10 ratio of reserves to liabilities (what the bank owes those depositors) was regarded as unexciting. So the ratio of capital to liabilities shot up to 1 to 20 and then to a dizzying 1 to 30 or more. The more the banks lend out, the more money they can make from the interest they charge.
By early this year British banks had Level 1 assets (cash and other highly liquid assets) representing only 4 per cent of their liabilities. But they assured everyone that they were fine because they had nice piles of asset-backed securities – based on the notorious sub-prime mortgages. Basically these were a cheap and convenient way of bulking up their holdings.
A year ago in the Risk issue I wrote a piece entitled "Waiting for the bodies to float to the surface" which pointed out that these supposedly sophisticated financial products were fool's gold. Twelve months later the corpses of a dozen or so financial titans have indeed materialized.
In other times this might have left the survivors looking quite good. But this time there is a gnawing problem of trust. The source of the credit crunch is the refusal of banks to lend to one another. Really what the banks were saying was that they would not trust their rivals because they believed that, like themselves, these rivals were still concealing toxic assets. This is an interesting twist on what Jean-Paul Sartre called the logic of seriality, in which we all become aliens to one another. In this version the banks don't trust each other because they suspect that the other is just like itself, flattering solvency by basing it on dud securities.
The British authorities have offered to recapitalize the banks and to guarantee their lending to one another. This leaves the government intimately involved in running the banks. The banks don't have to trust one another because they have a guarantee. Like a pre-nup, this is unromantic but effective. It solves one problem of trust but creates another. The scheme leaves the public purse underwriting the whole miracle of credit. In future the public might believe themselves likely to run it better than bankers whom they just don't... trust.