How Banks Go Up in Smoke

On 18 June 1982 the Italian banker Roberto Calvi, head of Milan’s Banco Ambrosiano, was found hanging under Blackfriars Bridge in London. His pockets held bricks and about fourteen thousand dollars in three currencies. The London police decided at first: suicide.

Dickie writes that Calvi had in many ways followed in the footsteps of another notorious banker, Michele Sindona. Both rose early, were friendly with the Vatican, gave money to political parties, crashed, fought desperately to save themselves and blackmailed politicians. Both belonged to the secret Masonic lodge P2. Only in April 2002 did the Italian authorities accept that Calvi had not killed himself. He’d had help. The prosecution rested on the account of yet another mafioso turned pentito: Calvi had been laundering Mafia money just as Sindona had, and when he stopped inspiring confidence, he was murdered. In 2007 the court acquitted the defendants. But it accepted that it was murder.

And the bank? When Banco Ambrosiano collapsed, it was short of about one billion two hundred and eighty-seven million dollars, which had gone out through shell companies abroad. The Vatican bank had links to those companies. In 1984 it paid the creditors two hundred and twenty-four million dollars without admitting guilt—“in recognition of moral involvement”. Nicely put. In our world we’d put it more simply: it paid for silence.

In The Godfather Part III—mind you, this is a film—a banker is found hanging under a bridge, and a deal with the Vatican bank turns out to be a swindle. The screenwriters made nothing up. They just put the newspaper headlines on the screen.

Anatomy of a Bank That Will Burn

Want to understand how banks go up in smoke? Let’s build a little bank ourselves.

You put ten of your own money into it—that’s the capital. Depositors bring in another ninety. You lend out the whole hundred. Borrowers pay you, say, seven per cent, and you pay depositors three. You keep the difference, and on ten of your own money that comes to a great deal, because you’re working with a hundred.

Now suppose borrowers fail to repay a tenth. Ten out of a hundred. What’s left of your capital? Nothing. You still owe depositors ninety, and you have exactly ninety. One more borrower doesn’t pay—and you’ve nothing to pay with.

This is called leverage. The less of your own capital stands behind every dollar you lend, the fatter the bank’s earnings in good years. And the faster the bank dies in bad ones. In 2003 the investment bank Lehman Brothers had about twenty-four dollars of assets for every dollar of capital. By 2007—thirty-one. A fall of a little over three per cent in the value of its assets, and the capital was gone. In September 2008 that’s exactly what happened.

The Run

There’s a second way to burn. Even when the loans are good.

A bank borrows short and lends long. A depositor can take his money out tomorrow, while the mortgage was granted for twenty years. As long as depositors don’t all come at once, there’s nothing to fear. When they do, there’s nothing to pay them with: the money is sitting in other people’s houses.

On 14 September 2007 the British bank Northern Rock asked the Bank of England for emergency support. The news hit the papers, and by morning there were queues outside its branches. Depositors hadn’t stormed a British bank for a hundred and fifty years. Northern Rock lent money for buying houses, but it didn’t get that money from depositors: it borrowed short-term on the wholesale market from other banks. In the summer of 2007 that market froze, and there was nowhere left to borrow. The bank wasn’t hopeless. It just couldn’t make it to tomorrow. In February 2008 it was nationalised.

Remember how in 1906 one rumour nearly set depositors running on a little bank in Little Italy? In a hundred years only the queue got longer.

The Insurer That Burned Down

And the third way, the most modern. Banks learned to insure their loans. You buy a contract from an insurer: if the borrower doesn’t pay, the insurer will. It’s called a credit default swap. A useful thing. As long as the insurer can pay up himself.

The American insurance company AIG, through its financial products division, sold such contracts worth hundreds of billions of dollars, insuring top-rated paper, much of it stuffed with that very same mortgage debt. It seemed it would never have to pay out, so AIG held little capital against them. Then the mortgages crumbled, AIG’s own rating was cut, and collateral was demanded on every contract at once. On 16 September 2008, the day after Lehman went bankrupt, the Federal Reserve Bank of New York gave AIG a credit line of up to eighty-five billion dollars and took nearly eighty per cent of the company in return. All told, the rescue ran to more than a hundred and eighty billion. AIG later paid it all back, and the government even made money. But if it hadn’t been saved, everyone insured with it would have burned too.

Remember the camorristi’s wives who didn’t trust the clan’s cash box? It vanishes exactly when you need it. AIG was the clan’s cash box for the whole world’s financial system.

A Bank on the Needle

One more lesson: central bank money cures panic, but not a hole.

The financier Michele Sindona, whom I’ve mentioned already, bought control of the American Franklin National Bank, one of the country’s big banks, in 1972. According to the investigation, he siphoned tens of millions of dollars out of the bank to cover what he’d lost speculating on currencies. When it came out, the depositors ran. The bank stayed afloat by borrowing from the Federal Reserve and ended up owing it more than a billion dollars. It didn’t help. On 8 October 1974 Franklin National was declared insolvent. No bank that big had ever failed in the United States before. A lender of last resort can buy a bank time. It can’t give back what was stolen.

The Don’s Rule on Debt

Don Vincenzo was no banker, but he had a rule on leverage. Everything the laundries and the oil trade owed between them—to suppliers, in rent, for the press—was never to exceed what we earned in a month. If the debts outgrew a month, we bought nothing new until we’d paid them off.

Once I asked: why a month exactly? “Because I can imagine a month with no takings at all,” the Don replied. “If in a month like that I owe more than there is in the till, the creditors will bury me. If I owe less—only the strikers will.” He was joking. The figure was serious. You don’t choose your leverage for good times, but for the worst month you can imagine.

The Bottom Line

A bank can burn from a loss, from a queue at the door, and from an insurer who couldn’t pay up himself—and most often from all three at once. Central bank money buys time. It doesn’t close the hole.