Twofish's Blog

January 21, 2009

It is good for a ship to sink inefficiently

Filed under: austrian economics, china, finance — twofish @ 10:23 am

Observer: Inefficient DOES NOT mean less systemic risk, says Chinese banks of the 90s.

It does, and the experience of Chinese banks in the 1990’s illustrates nicely my point.

Lehman Brothers was only about to be insolvent for about a week before it stopped operating. Chinese state banks were able to continue to operate for about a decade even though they were insolvent, and that was because they were highly “inefficient.”

The reason for this is that Lehman had about 3% of their assets in cash or near-cash equivalent. Chinese banks in the mid-1990’s had about 50% of their assets in cash or near-cash equivalents. What this meant was that the second Lehman went insolvent, it was game over, whereas Chinese banks in the 1990’s could continue to operate even though they had huge amounts of debt, because they had large holdings of cash.

The same is illustrated by the commercial banks in the US. Investment banks were leveraged 30:1. Commercial banks are leveraged 10:1 and have a cash line from the government. What this means is that investment banks had days to deal with insolvency, US commercial banks have months, and Chinese banks in the 1990’s had years.

Where the US ran into trouble is having cash reserves and not using leverage is seen as inefficiency, which it is. If you have cash reserves and you don’t use leverage, you are big and slow. But if you hit an iceberg, then you *want* to be big and slow, because the bigger and slower you are, the more time it takes for the ship to sink and the more time you have to do something. If you have five years to fix a problem, you can do all sorts of things that you can’t do if you have five days or even five hours.

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