There are two major problems in the world economy today:
1. Collapse of banks
2. Collapse of the economy.
In Keynes' General Theory, banking collapse is ignored. The focus is purely on the role of expectations on money demand and investment - in this sense: as uncertainty increases, people keep cash and forgo investment - even if interest rates are lowered to near zero, because the objective of people is to preserve capital value (don't lose money) rather than seek out the higher return (as investors would do).
How do banks collapse? Banks collapse when their bad loans are greater than their capital and reserves. Banking is a very tricky business which requires one to understand simple arithmatic.
Banks expose themselves fully in return for a fraction. If the rate of interest is 10%, a bank lends RM100 to earn RM10 - which means that if there is just a single default (say, RM100), then the bank has to lend out 10 good loans (with no default) earning RM10X10 to cover the default. If the rate of interest is 5%, then the cover is 20 good loans (RM100X20) to earn (RM5X20) to cover the RM100 default. So, if banks are earning a net margin of only 1% (lending rate minus cost of funds minus cost of operations), then we are talking about a cover of 100 times - our terminology for saying that we need 100 good loans to cover 1 bad loan of the same size.
Banks therefore cannot afford to have default. It is a basic banking rule that, if the borrower does not have a good credit rating, don't lend; a higher rate of interest cannot do any justice to lending to bad borrowers. (I lifted this remark from an old banking handbook I read long ago from an old timer who wrote the manual for the Bank of America, if I remember.)
Now, if banks are consciously going after bad borrowers, i.e. sub-prime customers, then they are really looking for trouble. I don't think the bankers and their regulators, especially in the US under Greenspan, understand that.
Now, if banks are lending out 400 times this capital and reserves, then they are really in big trouble. In other words, they have RM1 in capital and reserves for every RM400 they lend out. If they have a default of RM1, they are in trouble. That RM1 default is only 0.25% of their total loans. In other words, at loans 400 times the capital and reserve, they can only afford an NPL (non-performing loan or bad loan) ratio of only 0.25%.
Of course, they are relying on the return of the remaining RM399 to pull through, especially on the expecteed larger rate of return - which simply means higher risks. The scene is thus set for banking collapse.
Using our earlier example of a 5% net return (being generous), we are saying that a RM1 default requires RM20 good loans to cover. So the breakeven NPL ratio is 4.76%, very close to the net rate of return. If the net rate of return is 1%, then the breakeven NPL ratio is 1% from loans.
If we add in the capital and reserves for cover (formally called the capital-adequacy ratio), then the breakeven NPL ratio for a bank is the sum of (i) net rate of return (say, 2%) and (ii) the capital-adequacy ratio (say, 10%). I think you can do your own sums for individual banks.
Proviso: The NPL ratio is a tricky thing. In a booming economy, the NPL ratio is small; in a bad economy, the NPL ratio is high. Why?
Your answer is wrong - that the amount of bad loans increases in a bad economy. Half of the correct answer is that the amount of bad loans increases under all circumstances - during both good and bad times.
The full correct answer is that, in a booming economy, banks are happily giving out loans such that the amount of new loans is larger than the increase in bad loans. In a bad economy like now, bad loans are rising ("I see bad loans arising") while new loans are hard to come by or, if the banks are cash strapped, they may recall the good loans and shrink their loan base. (The latter is called a credit crunch.)
Bad loans don't come, they pour.
The bailout of banks and financial institutions is only one part of the rescue.
Do you save banks that do not know how to do banking? The last time I was asked by the Board of Directors of a bank to study the major cause of bad loans, my answer was that loan growth was excessive.
Now, why would banks be reckless in giving out loans. Because the deposits are not theirs. Half the answer. The other half (in light of a swinging stock market) is that the CEO's renumeration is tied to his ESOS which depends on the share price to make him an instant multi-millionaire. The only for a bank to push the share price is to register rapid loan growth which is good for earnings as well as for the low NPL ratio and the capital and reserves.
The real test of the strength of a bank is during bad times - to see how little their loan book is bad.
Not only that, whether during trying times, the bank understands the economics and the economic structure and what's happening in the world economy and how new opportunities can be tapped for future growth.
A bank that has relied on bad lending policy such as by lending to shares and real estate and consumers will not know what to do during trying times. Its CEO just bails out
The future of a nation is really dependent on the foresight of its bankers (and dare I say central bankers).
The banker must be able to see like an entrepreneur (but without being greedy himself) and works with the businessman or corporation to go for new opportunities. It is the support a good bank to a good customer that is the backbone of a vibrant economy. If a country has bad bankers and bad businessmen, then the country in for a perpetual series of bailouts in the name of pump-priming or whatever the fancy names that Keynes has invented.