By Jeff Harding
If you picked up a book on the Crash of ‘08 and started reading it in the middle and then based your ideas of how to solve future crises on that information, you would come up with ideas like the ones proposed by Martin Wolf, the chief economics reporter for the Financial Times. Mr. Wolf, whom I think is an astute observer of current economic events despite his Keynesian leanings, wrote an article on how to “fix” banks.
We all recognize that we have a problem with our existing banking system. As he correctly puts it, “without radical changes, another crisis is certain.” Mr. Wolf argues that, “[W]hat has emerged after the crisis is … an even worse financial system than the one with which we began. The survivors are an oligopoly of “too-big-and-interconnected-to-fail” financial behemoths.” He wants to go after the financial incentives driving banks.
Now, there isn’t such a thing as “too big to fail.” But within the context of current banking regulations and a regulated economy, the government has allowed banks to take far too many risks. Because of the connectedness of the world’s banking system their flaws are magnified into an international economic threat. When these “financial behemoths” fail, they jeopardize the entire world economy. But then they are the children of government regulation.
Before I get into Mr. Wolf’s suggestions I would like to give you the free market view of banking and how our banks contributed to the crisis.
We all understand that our banks create money by lending out more than they have in deposits. If your bank has $100 million of deposits, they could lend out $1 billion. This is called fractional reserve banking and it is the main flaw in our banking system.
Let’s assume that you suspect that the bank where you deposit your cash might be in jeopardy. Let’s then assume all their loans went to residential real estate developers and the loans went bad. You would have a problem and, like me, you would run to your bank to get your money out. Of course that just makes the situation worse and your bank fails. You lose.
Forget for the moment that your deposit is insured by the federal government (FDIC). What will you do the next time you have money to deposit in a bank? Stuffing it under a mattress is not the correct answer. You would probably want interest on your deposit. Say that BancoFlagrante offers you 6% on your money if you keep it in for one year. BancoConservo offers you 2%. You decide to do some checking up on these banks and find that BancoFlagrante is leveraged out its capital 10 to 1 but BancoConservo is only leveraged out 0.5 to 1. You also find that BancoFlagrante has 90% of its loans in real estate and BancoConservo only has 10% of its loans in real estate. Which bank would get your money? Having gone through this before, I am confident you would choose BancoConservo as the best bet to get your money back; you wouldn’t risk losing your money to get the extra 4% return.
Which bank is taking the most risk with its depositors’ money? It is obvious that BancoFlagrante is taking great risk to achieve the 6% return on their deposits. No depositor would risk depositing money with such a bank. If people wanted to invest in real estate they would do so directly and knowingly take the risk and potentially greater reward (better than 6%). Yet that is what is happening in our banking system today.
In 2008 US banks were lending out 87% of their deposits (or 93% by simple averaging).
Wolf points out in his article that US banks capital ratios are historically very low, below 10%. Capital ratios are complex weighted averages based on Tier 1 capital, which is basically the equity invested by bank shareholders plus retained earnings. Another term for it is “skin in the game.” The minimum requirement is 4% (minimum 8% for Tiers 1 and 2). The big U.S. dealer banks showed Tier 1 capital ratios ranging from about 7% to 14% as of December, 2008.
Why do banks take such risks?
Answer 1:
They can get people to deposit cash with them because people don’t care about risk. Why? Because the federal government (FDIC) guarantees deposits up to $250,000. If the bank craters, depositors know they will get their money back from the government.
To look at it another way, you, the taxpayer, are incentivizing banks to take risks by insuring their risky behavior. Only the government would allow banks to do such a stupid thing. Ask yourself, based on what you know today about the Crash, would you invest in any private insurer that would insure such risks? Would any private insurer insure such risks today?
Answer 2:
The shareholders of banks have a great scam: they can start up a bank with only 10% equity and lend out 100X that amount. It’s called leverage and that greatly magnifies their returns. It’s not their capital that is mostly at risk: it’s yours. If most of banks’ loan capital comes from depositors, the shareholders are more willing to let management roll the dice in exchange for big returns.
What is the “fix” suggested by Mr. Wolf?
For the most part they are good things: raise capital ratios and lower the loan to debt ratios. But, he would have regulators determine which institutions are “systemically significant” and require tighter financial practices for them. His regulators would be able to adjust financial requirements during booms and busts. He suggests more regulation for the shadow banking system (the systemically significant brokerage houses, hedge funds, insurance companies) in order to prevent systemic risk.
All these suggestions sound good until you imagine giving our already incapable regulators more power over the financial system. Government already has substantial authority over these institutions and failed us in cycle after cycle, so I don’t have much faith in more regulation doing anything helpful and I can think of many harmful things they could do to the economy in their zeal.
Mr. Wolf misses the most important fix of them all: doing away with FDIC deposit insurance. All FDIC deposit insurance does is create systemically significant risk. It is just another government program that may be well meaning but runs into the law of unintended consequences. By giving our bureaucrats power to insure deposits we have created systemic risk, not cured it.
Mr. Wolf should also look to the cause of business cycles such as the current one: the role of easy money created by central banks around the world.
It’s not too terribly difficult to imagine a world without the FDIC. Like me, you probably wouldn’t deposit your cash in a bank without deposit insurance provided by private insurers. Such insurers, facing potentially large losses from risky lending practices, would require banks to conform to safer lending standards. It is not difficult to see that this would go a long way to eliminate fractional reserve banking and get us back to rational banking practices. Fractional reserve banking is inherently risky. Without the ability to lend far in excess of their deposits banks would not be able to inflate the money supply. Who knows, maybe we’d go back to a gold standard of banking.
Can’t people think of ways to solve problems other than granting more power to government?
It’s a perfectly possible solution. It’s the sort of solution American conservatives have been proposing to many problems over the past three decades. It suffers from only one small problem: the chances of its being adopted are zero. Personally, I have no interest in being Don Quixote.
By the way, financial crises are not merely possible, but quite likely, even without deposit insurance.
The problem with the commitment not to bail out depositors is that it is completely non-credible. That means depositors will behave as if insured. This also means that when a crisis erupts, no elected government will be able to let the vast deposits in the system vanish.
The big weakness of the libertarian position is the refusal to recognise that it is absolutely incompatible with democracy.
You may be unaware that the UK had an extremely limited form of deposit insurance, as you recommend. Did people act as if they were not going to be rescued? Of course not.
So what happened when there was a run on Northern Rock? The government guaranteed deposits ex post. What would have happened if it had not done so? There would have been a run on all banks. The central bank could have acted as lender of last resort, but the banks would have soon started to run out of good collateral, since they were, in aggregate, insolvent. At this stage the government could have followed your advice and allowed the banks to collapse. The economy would have followed.
What would have been the political consequences? Labour would have benn wiped out, permanently.
The pure capitalist position is an irrelevance. It has nothing to do with practical realities.
It always hurts to be called a (i) “conservative” and (ii)” irrelevant.” But before we advocates of the free market are relegated to the dustbin of history, let me make a few observations.
1. My comments were directed to the US system not the UK.
2. You misunderstood the argument if you think deposit insurance would not exist if the FDIC were dismantled. It would. The big difference is that the social and economic cost of it would be borne by banks and their depositors, not taxpayers.
3. In your article you state that it would take some time to implement new, stricter capital and loan to deposit ratios. I agree, with or without deposit insurance, this must be done. So give me the benefit of at least not being a complete idiot. While we are doing this, we would also take deposit insurance private over time so as the banking system would not collapse. My guess is that insurers would line up to offer this service.
4. A private system of deposit insurance would not be subject to so much political control as a public one. This is the great failure of most regulatory schemes. They rarely achieve the desired ends, and, as I point out, the ends are destructive to the economy. Public deposit insurance on top of fractional reserve banking lead directly to the meltdown. It has been shown that when the FDIC raised insurance to $250,000, banks who were in trouble actually took more risks by offering high rates on deposits to get more capital to gamble with and to help stay the inevitable. They failed anyway. Who’s tilting at windmills, here?
5. I understand your “democracy” argument but it’s also a straw man. Your fear is that if we don’t placate the masses, we’ll find ourselves in a totalitarian system as demagogues gain power. So, if we give a little more power to the central government we’ll thwart a coup d’état. What rubbish. Maybe in the UK that’s your tradition. Here we fancy ourselves as a constitutional republic first and a democracy second. You should think about adopting a constitution. Private deposit insurance is completely compatible with our system. I am not unmindful of our history during the Great Depression and the same argument was proposed then. (If you think those New Deal regulations saved democracy, I would be delighted to argue that point as well.)
6. Your argument about lack of credibility is relevant. But not the point. You can’t just assume there would be no deposit insurance without the government. Let me ask you: where would you put your money if government policy was made clear that it wouldn’t be the banker of last resort? Would you put in a bank with private deposit insurance or one without it? It wouldn’t be a stretch of the imagination to believe that insurers would act as bank auditors to protect themselves and their shareholders. The only reason this isn’t on the table is because politicians want more power, not because it wouldn’t work.
7. I agree that there would have been a run on all banks when Northern Rock went down. So what? That is the system that now exists. That wasn’t the argument. The argument is: what is the best fix? By the way, sitting here on the shores of the Pacific Ocean I would say the idea of Labour ceasing to exist is not an abhorrent thought.
8. “Irrelevance” is not an argument. What works and what doesn’t work is an argument. I say FDIC deposit insurance made things worse. I think that’s a practical and relevant point. If you wish to cling to outmoded and failed Keynesian or Fabian socialist ideals of government action that’s your business. But at least admit the failures.
Thanks for the comments.
We got into the current mess because bankers thought that they were not really risking anything getting into make-believe finance: Screw up real bad and we’ll get bailed out. Greenspan set the “Too Big To Fail” precedent with LTCM.
As for the question of what the body politic might tolerate, who knows? If things get much worse, folks might start calling for a Man On A Horse to save them. We should just go with the flow in that case in order to remain “relevant,” I suppose.
The banker’s really weren’t risking anything. The people who trusted them with their money took the risks
Heads I win, tails you win.
me a job where the pay’s really good
I shafted my company, but why should I fear
My pension is still half a million a year
And that’s why
I’m a banker, I’m a banker.
I don’t give a dang if that is rhyming slang
I’m a banker, I’m a banker
‘Cause I’m only doing my thang
I am just fifty years old, but it’s time to retire
My pension pot’s eight million.. it needs to be higher
So they’ll give me sixteen mil. although I’m the pits
Maybe that’s what is meant by “Double or quits”
It’s sky high…
I’m a banker, I’m a banker.
You’re broke down there? Well, I don’t fucking care
I’m a banker, I’m a banker
Just as long as I get my share
Oh, Mr Brown and your taxpayers’ money
Thank you for paying me, and saving my behind
But one pain in the arse, all this coverage ain’t funny
I’ll fly off somewhere sunny, I don’t like being maligned
Good win on the lottery, good win on the pools
Godwin out of RBS – who cares about rules?
I’ve lied to shareholders, I’ve lied to MPs
I’ve lied to the treas’ry Select Committee
What’s a lie?
I’m a banker, I’m a banker.
I find numbers fun, and I’m number one
I’m a banker, I’m a banker
And I do like shooting my gun
Oh, Mr Brown and your chancellor Darling
Thank you for making me so glad to be a Brit
Now you want my cash back, but I won’t give you a farthing
I don’t want to start quarr’ling, so I’ll leave you in the s**t
I’m a banker, (He’s a wanker!)
I’m a banker. (He’s a wanker!)
I don’t give a dang (He doesn’t give a damn!)
If that is rhyming slang
I’m a banker, (He’s a wanker!)
I’m a banker. (He’s a wanker!)
‘Cause I’m only doing my thang (He doesn’t give a damn!)
I meant, heads i win, tails you loose. Sorry.
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