How did the credit crunch and banking crisis happen? Often asked and often discussed. Someone realising that easy credit is a great way to grow a business. Then someone worked out that credit derivatives is a great way to make lending appear safe and sound, even when perhaps it isn’t. From then on, everyone had fun growing the economy. But all good things come to an end.
Lizzy is the Owner of a Bar in the City …
She realizes that virtually all of her customers are unemployed alcoholics and, as such, can not afford to patronize her bar. To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later. Lizzy keeps track of the drinks consumed on a ledger (thereby granting the customers loans). Word gets around about Lizzy’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Lizzy’s bar.
Easy Credit Grows any Business (and any Economy)
Soon she has the largest sales volume for any bar in the City. By providing her customers freedom from immediate payment demands, she gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Lizzy’s gross sales volume increases massively. Soon after Lizzie is invited to the Town Hall to help advice local politicians how to increase the amount of business on the high street.
What About Lizzie’s Overdraft?
A young and dynamic bank manager at the local bank identifies Lizzie as his fastest growing most profitable business customer. He recognizes that the customer debts constitute valuable future assets and increases Lizzy’s borrowing limit. He sees no reason for any undue concern because he has the debts of the unemployed alcoholics as collateral!
And Banks Like to Make More Money (in any way they can)
At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKIBONDS. These “securities” then are bundled and traded on international securities markets. Investors don’t really understand that the securities being sold to them as “AAA Secured Bonds” really are debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb – and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.
But all Good Things Come to an End!
One day, even though the bond prices still are climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Lizzy’s bar. He so informs Lizzy. Lizzy then demands payment from her alcoholic patrons. But, being unemployed alcoholics — they cannot pay back their drinking debts. Since she cannot fulfill her loan obligations Lizzy is forced into bankruptcy. The bar closes and Lizzy’s 11 employees lose their jobs.
First Casualty: the Suppliers,
Overnight, DRINKIBOND prices drop by 90%. The collapsed bond asset value destroys the bank’s liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community. The suppliers of Lizzy’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the DRINKIBOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.
But What About the Banks?
Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi billion pound no-strings attached cash infusion from the government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Lizzy’s bar.
And the Morale of the Story is?
If there isn’t one – We are all doomed! Perhaps there is a lesson for everyone that building a business based on value rather than credit and managing a business for cash flow rather than profit has more longevity, more to offer for the stakeholders and ultimately offers more satisfaction and pride for everyone involved. And plenty of businesses are trading strongly through the economic conditions. They pay attention to delivering value to their customers and managing their cash flow at the same time. They spend little time with their bank manager because they don’t need him.