On the credit cycle:
It is only net new lending that stimulates, and total new lending has to keep rising in order to keep net new lending stable.
The process continues until a point is reached where total credit cannot increase fast enough to continue stimulating the economy. By that time, collateral values have become greatly dependent on the stimulative effect of new lending and, as new lending fails to accelerate, collateral values begin to decline.
Eventually, the realization that the trend is unsound and unsustainable comes crashing in. The prophecy is self-fulfilling and the trend is reversed, often with catastrophic consequences. ... the boom is drawn out and acelerates gradually; the bust is sudden and often catastrophic.
On International Lending:
... international lending was too profitable to leave much room for caution. Business could be transacted on a large scale, the risk of adverse interest rate movements could be minimized by the use of floating rates, and administrative costs were much lower than in the case of corporate loans. Fierce competition kept spreads between borrowing and lending rates quite narrow; nevertheless, international lending became one of the easiest and most profitable forms of banking activity, attracting many banks with no previous experience in the field. ...more than a quarter of Citicorp's earnings came from Brazil. ...international lending became the fastest growing sector of the banking industry. Naturally, if banks had set up reserves that would have been appropriate in light of the subsequent experience, the business would not have been as profitable as it seemed at the time.
Banks were so anxious to obtain business that they asked very few questions. It is amazing how little information borrowing countries had to supply in order to obtain loans. Lending banks did not even know how much money the countries in question were borrowing elsewhere.
International lending grew so rapidly that the banks involved became overextended: their capital and reserves could not keep pace with the growth of their balance sheets.
The larger banks typically leveraged their equity 14 to 16 times, with the Bank of America running as high as 20 times. ...many banks had reached the point where they were pushing against the limits of what was considered prudent leverage by the standards of the time. If they wanted to continue growing they would need to raise additional equity capital.
On the reasons for the international lending boom and regulators response to it:
Why the commercial banks were willing and able to sustain such explosive growth in their international loan portfolios is a fascinating question that will be hotly debated for years to come. Part of the answer is that banks did not consider themselves responsible for the soundness of the system. Banking is an intensely competitive business, which is, however, subject to regulation. It is the job of the central banks to prevent excesses. Commercial banks operate under a protective umbrella; they seek to maximize their profits within the framework of existing regulations and they cannot afford to pay too much attention to the systemic effects of their activities. A commercial banker who refuses to go after what seems like profitable business is liable to be pushed to the side, and even if a bank decided to abstain there are many others anxious to take its place. Thus, even those who realized that the international lending boom was unsound found themselves obliged to participate or lose their places.
There is an important lesson here: participants are not in a position to prevent a boom from developing even if they recognize that it is bound to lead to a bust. That is true of all boom/bust sequences. Abstaining altogether is neither possible nor advisable. The best a participant can do is to cease to be a participant at the right time.
The history of central banking is a history of crises followed by institutional reform. It is truly surprising that the lessons of the international debt crisis have still not been learned. The champions of unregulated competition are more vocal, and more influential, than ever. ...regulations are generally designed to prevent the last mishap, not the next one.
Why did the [regulators] fail to [regulate international lending?] ... Had the [US regulators] imposed regulatory restrictions [on US banks], the banks under their supervision would have lost business to [foreign banks].
Thoughts for the future:
Monetarism holds that inflation is a function of money and not of credit. If monetarism is valid, the growth of money supply needs to be regulated, not the growth of credit.
...I can point to the empirical evidence that shows that the money supply always fails to behave in accordance with regulators' wishes.
Economic activity takes place in the "real" economy, while the extension and repayment of credit occur in the "financial" economy.
the Collective system is held together only by the threat of breakdown.
-George Soros
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