Why Are Banks Too Big to Fail?

How the Asian Elite Rob the Poor to Pay the Rich

How the Asian Elite Rob the Poor to Pay the Rich

Following government orders, central banks and commercial banks worked together to make the “Asian Miracle” happen. Over the past few decades, Asian economies have all seen double-digit GDP growth and relatively stable political regimes.

But in the process, they’ve bailed out the bad guys, muzzled entrepreneurs and forced taxpayers to pick up the tab.

How central banks work

The majority of commercial banks in Asia are technically “independent” except for some cases in China and Vietnam. At times, they can rise above the government and partner with non-democratically elected entities like the IMF, the World Bank and the Asia Development Bank (ADB).

The leader of the International Monetary Fund (IMF), Christine Lagarde. (Shutterstock)

But they can be also used as a tool by central banks and governments to manipulate the economy.

All commercial banks are inextricably linked to the central bank, as it is the main governing body for banking regulation and codes of practice.

How did central banks get so big in Asia?

Most Asian countries have maintained trade surpluses with the U.S. for some time. As a result, their balance sheets have ballooned.

Sun Yat-Sen’s portrait on the New Taiwan Dollar (translation of Chinese characters: Central Bank of R.O.C)

Let’s look at the mechanics of how these surpluses are accumulated. A central bank has domestic and foreign assets. Its liabilities are currency that circulates throughout the economy and the custody it maintains on commercial bank reserves.

For example, let’s say the central bank “creates money” to buy a security from a commercial bank. The newly purchased asset is held by the central bank and the commercial bank is capitalized with the new funds.

You can see this in the figure below, the typical balance sheet of a central bank.


So what’s the difference between foreign and domestic assets?

Domestic assets are locally-issued securities or gold held by central banks. Whereas foreign assets are securities issued by foreign countries. You’ve probably heard about China holding billions of dollars worth of U.S. Treasuries (debt) as part of their reserves. Foreign reserves are one kind of foreign asset a central bank owns.

Most foreign reserves in Asian countries are in USD dollars. Asian foreign reserves have grown because Asian countries have had huge trade surpluses with western countries – bringing U.S. dollars into their countries.

As you can see in the figure below, China has mastered the art of imbalanced trade with the U.S.

This is because China specializes in “processing trade”. It imports raw unfinished goods like hard disk drives and then “processes” (assembles) them. Finally, the processed goods are exported abroad at a higher price.

That’s why the back of an iPhone reads: “Designed by Apple in California Assembled in China”.

In fact, it turns out that balance sheets across Asia are bigger than they are in Western countries, as you can see below.

The combined size of the balance sheets across the region increased from US$1.1 trillion in 2001 to US$6.4 trillion in 2011.

Trade surpluses in Asia are a driving factor behind the region’s massive balance sheets. Meanwhile, these huge foreign reserves have funded the region’s economic development.

The Asian exception

Countries in Asia – especially in the north eastern part of the region – have seen huge economic growth in relatively short time periods because they followed window guidance as opposed to the free market. We’ve discussed in detail how window guidance works in detail in previous articles, (see window guidance publication) but we’ll recap briefly.

Governments in Asia decided that industrial and manufacturing activities – like shipbuilding and making wind turbines – were their “competitive advantage” in the global economy.

Workers in Jiujiang, China use new technologies to produce sanitary products, which are exported to Europe and the United States, Australia, Japan and Southeast Asia.

To raise money for these economic development projects, the government issues bonds. It tells commercial banks – through the central bank – to buy these bonds.

The government takes the cash from these bonds and invests it in whatever development project it chooses. This boosts market liquidity and the circulation of money in the financial system.

Sometimes these projects turn out to be profitable and the government can pay the commercial banks back with interest.

But sometimes these projects fail. This is known as a non-performing loan. When this happens, the central bank comes to the rescue – adding the government’s debt to its balance sheets.

Toxic debt disappearing act

Non-performing loans otherwise known as bad debt – is a feature of every economy, especially in Asia.

So how do Asian economies “clean up” all of those NPLs and keep their banks treading water?

They create special “Pac-man” like asset management companies (AMCs). These AMCs in Asia are state-owned enterprises, and their job is to buy (eat) NPLs from commercial banks.

Instead of buying bank debt with cash, AMCs issue bonds at the same value of the debts purchased. And Commercial banks can “cash out” the bonds at the central bank.

China has four major state-owned AMCs matched with four of its major state-owned banks, as you can see below.

South Korea also went through a period using AMCs to swallow bad debt. State-owned KAMCO was created to swallow up distressed assets from banks and credit card companies.

In 1998, Korea Asset Management Corporation (KAMCO) took over half of the estimated KRW100 trillion non-performing assets (NPAs) at South Korea’s financial institutions. By December 2002, KAMCO had accumulated over KRW110 trillion worth of NPAs.

But by 2003, KAMCO had stopped its NPA buying spree and now only purchases bad debts from troubled credit card companies.

Vietnam Asset Management Corporation (VAMC) – was created in 2013 by the government and fulfills the same responsibilities as “bad banks” in neighboring countries. Its mandate is to purchase bad debts from the banking sector and restructure the loans.

All of these “bad debt collectors” are able to make NPLs disappear because the central bank, as usual, refinances the bad debt with the money it issues.

Who’s left with the bill at the end?

If beauty depends on the eye of the beholder, then in the eyes of government officials and bankers, the policy of bailing out banks is certainly beautiful.

It lets officials and bankers reap all of the profits when the loans perform. But when they don’t, guess who pays off the bad debt? The average taxpaying Joe or in this case, the average Nguyen, Kim or Zhang foots the bill.

Governments in Asia consistently bail out banks and direct credit through window guidance because they seek growth and stability at all costs. By directing credit to strategic sectors, they are able to maintain high growth levels.

By setting up AMCs to slowly “eat up” bad debt, failures in the banking system can be swept under the carpet.

This might sound like a bad deal for the taxpayer, but it’s just how things work in Asia. Understanding where debt is directed and where bad debt goes is key to investing in the region.

In our next daily, we’ll show you exactly how banks in Asia make a buck off of this twisted system, so you can too.