One of the surprising things I repeatedly observed as a CEO of a public company investing in financial services in Africa was that banks there—and in many emerging markets—don’t actually lend, at least not to businesses or people.
Rather than provide much-needed loans to fund working capital and help businesses grow or provide a mortgage for an aspiring homeowner, the banks primarily invest in the sovereign debt of their country’s government. These depository institutions are public banks in name but, in practice, are funding tools of the state.
In a highly inflationary environment, and one in which governments often can only issue debt by offering high single- or even double-digit rates of interest, this is a profitable business for the banks. And it is much less risky and complicated than traditional banking. Since African citizens and businesses often don’t trust their banks—or their governments—they keep their savings and wealth elsewhere if at all possible. This isn’t a particular concern for the banks, as they rely on deposits from well-intended but misguided nongovernmental organizations and nonprofits, as well as wholesale funding from development finance institutions sponsored by governments around the world.
We are seeing the U.S. banking system start to adopt this model.
After growing loans by more than 20 percent after lockdowns through 2023, banks have started to restrict private credit. As a whole, the banks are sitting on more than $500 billion in unrealized losses on investment securities, making additional lending problematic.
Since the end of the Global Financial Crisis, an increasingly onerous regulatory regime has fundamentally changed banking. Dodd-Frank in the United States and the internationally applicable Basel III, among other regulations, all with stricter standards for capital requirements, leverage, and liquidity, have collectively created an incentive system that penalizes traditional banking activities of deposit-taking and extending loans, as well as trading and investment banking activities, and rewards investments in “risk-free” government securities. No one can possibly know whether the banking system is any safer as a result.
This process of increasing co-dependence began after the bailouts of 2008–2010 effectively nationalized the world’s largest banks. Around the Western world, large banks are more beholden to government than ever, and Western governments to their large banks. If the banks comply, which they will as long as possible, they will keep their government from moving on to the final step in the financial Ponzi scheme, which is the monetization of the debt. This is the point at which no market buyers remain, and only the Federal Reserve (in the United States) and its peer central banks in the UK and the EU are left to buy government debt. This is the point when out-of-control inflation will really kick in.
The indebtedness of the governments, the condition of the banks, and the weakness of the consumer—all of this is negative for recovery from recession and for economic growth. Even in a weakening economy, with rising unemployment rates as we are seeing now, inflation is likely to reignite once the Federal Reserve lowers interest rates. This is the definition of stagflation.