Michael Pettis

Michael Pettis

13-11-2022

04:35

1/9 I remember that one of the biggest problems during the Mexican banking crisis of 1995 was that bank owners had illegally lent money to each other through their banks to increase the reported amount of bank equity capital.

2/9 Bank A would lend $100 to the owner of Bank B, in other words, and Bank B would lend a similar amount to the owner of Bank A, allowing them collectively to claim $200 of capital, even though there was no additional capital within the overall banking system.

3/9 The problem, of course, was that what seemed like a capital cushion for an individual bank was good only if an individual bank had a problem, but was useless in the case of a systemic problem.

4/9 Unfortunately this also all but guaranteed that a serious problem in one bank would quickly became systemic. That's because a decline in one bank's "capital" would automatically cause an equivalent decline in another bank's "capital" as the associated loan lost value.

5/9 It seems to me that this was exactly what happened in the crypto system. Each entity used assets issued by another to shore up its supposed capital. This just meant that the system itself operated on almost zero capital.

6/9 It also meant that a serious problem in any one part of the system couldn't help but spread rapidly throughout the whole system. This is actually a very easy problem to understand, and is well understood by even very junior bankers and regulators.

7/9 It suggests that either the leaders in this system were remarkably ignorant about how financial systems work (and willfully ignorant, because this is pretty basic stuff), or that they just didn't care about the systemic risks they were creating.

8/9 It's ironic that the crypto-currency system, which was supposed to be a better alternative to money and banks precisely because it was immune from these kinds of tricks and scams, ended recreating the most simple-minded and elementary financial mistakes.

9/9 This probably why their managers were all so eager to operated in unregulated jurisdictions. Everyone knows that during times of "exuberance", unregulated banks can make so much more money than their regulated counterparts by taking on huge amounts of risk.


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