Banking

[wphelan]

Banking. It's a subject I've been think of bringing up for a while now. I'm mainly interested in exploring the inherent problems with our current banking system and what, if anything, can be done about them.

Here's the article that prompted me to start this thread this evening: http://mises.org/story/3350

The title of the article is "Bring Back the Bank Run!" That certainly got my attention. Writing in 1990, the author of the article, James Grant, said:

In other words, by historical standards, the banks are loaned up. More than that, they are stuffed (many of them) with loans that were once considered inappropriate for the balance sheet of a commercial lending institution. The most prevalent specimen of this class of dubious assets is loans against speculative commercial real estate. As banks withdrew from business lending, they turned to property.

Clearly, the problem of over-leveraged banks got more out of control after the article was written, as we are well aware of now. But what is it about banking that changed that led to these problems?


Reserve requirements were reduced to 18% with the advent of the Federal Reserve System in 1913 and stand at 12% today [1990]. Loans as a percentage of assets are higher today than they used to be, however. And off-balance-sheet liabilities — such as standby letters of credit, interest-rate swap commitments, and futures-markets trading — are higher, too.

The rise in the risks attached to banking prompts numerous questions about the nature of lending and the credit cycle. How has the regulatory and monetary climate of the 1980s affected bank lending? If, as seems obvious, it has inflated it, what will be the consequences of it?

If anything is new about banking in our epoch, it is the substitution of federal guarantees for the liquidity of individual banks. It is the policy that, in the case of the 11 or so largest banks, failure will not be allowed and that, even in smaller institutions, depositors will be protected. It is this regulatory sea change that distinguishes the current debt expansion from so many earlier ones.

Years ago, when weak banks suffered runs by public depositors, instead of seizure by the Federal Deposit Insurance Corporation, a liquid balance sheet constituted a competitive advantage. When James ("Sunshine Jim") Stillman, National City's dour chairman, correctly forewarned his associates in early 1907 to prepare for a panic that fall, he was able to anticipate a competitive silver lining:

"What impresses me as most important is to go into next Autumn ridiculously strong and liquid, and now is the time to begin and shape for it. If by able and judicious management we have money to help our dealers when trust companies have suspended, we will have all the business we want for many years."

If, however, one's institution is beyond failure, it hardly makes business sense to build reserves against an unpredictable day of reckoning. What it makes sense to do is lend, and so banks have lent.

I've got some thoughts I'd like to add to all this, but it will have to come later. Just when I think I'm getting somewhere, something else comes up... Anyway, I'll post this as it is to perhaps spur some discussion of the banking system.

I know it's a big topic, but I find it pretty interesting. Capital requirements, reserve requirements, central banking, money creation, etc. This thread is about any or all those things.

[Michael]

Banking. It's a subject I've been think of bringing up for a while now. I'm mainly interested in exploring the inherent problems with our current banking system and what, if anything, can be done about them.


Excellent thread idea. It is a topic that I'm quite interested in - more so now than ever before. :)

Here's the article that prompted me to start this thread this evening: http://mises.org/story/3350

The title of the article is "Bring Back the Bank Run!" That certainly got my attention.

I especially like the last paragraph!

Is the banking dilemma eternal? It doesn't have to be. We could desocialize credit risk and let the bank runs take their toll. Absent federal meddling, the bottom line would be simplicity itself. The proof that banks have created excess credit would be found in the action of markets. It would be a fascinating picture if not a pretty one.

That's radical - but very interesting in the context of the present day. The present system socializes risks and makes them massive. The old way kept the risks entirely private and thus, while nasty, they were rarely large.

[Michael]

I had this written up and ready to post, not really sure where to put it - this thread seems to be the most relevant for it.

Changing Financial Regulations

There has been quite a bit of talk about developing and applying a whole new set of regulatory instruments in order to better regulate the financial/banking industry. Treasury Secretary Geithner (aka 'Timmy') has suggested that he supports this approach. Details still remain vague, though the Treasury has already moved to request new powers to enable the takeover failing financial/banking companies. This particular act is non-controversial - it is the next phase of the plan that has people interested.

Thursday, at a Congressional hearing, Mr. Geithner is expected to focus on changes that he believes are necessary to contain "systemic" risks to the economy. The Obama administration is working on other changes, too, including beefed-up consumer and investor protections.

Mr. Geithner is expected to call for a strict and consistent set of regulations for large firms, as well as more power for the government to monitor emerging risks to the economy. The new rules will likely require financial institutions to hold more capital as a buffer against losses and will bolster risk-management standards. All told, the proposals would mean significant expansions of power for the Treasury, Federal Reserve and other regulators.

Source (http://online.wsj.com/article_email/SB123799575291939189-lMyQjAxMDI5MzI3NTkyOTU1Wj.html)

I'm not particularly enthusiastic about this whole approach. Sure there is room to tinker with the details and certainly good cause to end the exemption of derivatives from regulatory authority. But otherwise, I think that existing regulations are pretty darn good ones - including the accounting principle of 'mark-to-market'.

In my opinion, the systemic danger here is that regulators are prevented from applying actual existing regulations - especially in the face of politically powerful interests that exert influence through Congress or the Whitehouse on the regulatory agencies - and/or 'agency capture' - a situation where regulatory agencies get staffed entirely by those with ties to the industry players and thus, the regulator ends up acting as a 'cheerleader' for the industry it is supposed to be regulating. The Federal Reserve, the SEC and the Treasury Department itself are the three biggest or best known 'regulators' of the financial industry, but there are dozens of such agencies out there and this problem applies to all of them. The Bush Administration in particular was notorious for installing industry shills onto regulatory boards. Indeed, this is a big part of how and why the present financial crisis came about. The existing regulations didn't fail - the regulators choose not to apply/enforce them.

On this basis, inventing new regulations that will be conveniently ignored like the old ones isn't a solution that inspires any confidence. The focus must be on how to improve the reliability of the existing regulatory apparatus. How to ensure that it will work when it is most needed.

For example (from the same news article source cited above)...

Mr. Geithner is also expected to call for changes in rules governing how banks conserve cash to cover losses, with the goal of allowing them to set aside more when times are good. He also will call for a review of "fair value" accounting rules that require banks to take losses when the price of their assets falls. Some critics argue such rules punish firms when they need help the most—during rough times.
This is hilarious. These 'critics' just don't have a clue what capitalism and the business cycle is all about.

When the 'bull turns into a bear' and the markets go down instead of up, that has the effect of weeding out the weak companies and rewarding the well managed ones. That's the logic of the business cycle - recessions punish the fools, the weak, the over-exposed and the heavily leveraged ones. Adjusting the accounting rules to protect/help the idiots survive when the markets turn against them does a great 'darwinian disservice' to capitalism - and helps foster exactly the kind of massive financial failure as we are witnessing now.

The point about good regulations is that they must be impervious to this kind of soft-hearted crony capitalism (or political capitalism) where powerful (and inefficient) companies buy political favors to avoid the rigor of actual honest regulatory rules - and then turn around and demand 'bailout' money from the taxpayer when they get caught over-leveraged and over-exposed in a falling market! :rolleyes:

[Americano]

Great post and definitely a contemporary subject.

If accounting rules are suspended or changed to use false market asset values our entire economic system will never recover from the bottom of this business cycle. We're still consuming far more than we produce and monetary inflation will make the Weimar Republic experience of trying to spend its way out of debt look like a beginners game. That's what many are after, Timmy is asking for a review, the SEC has the legislative power, and it makes my head hurt. Desperation.

[wphelan]

A passing thought I had today...

I think people overwhelmingly spend more time researching and thinking about what kind of television or car they will purchase as opposed to what banking institution they will trust the rest of their money with. Something doesn't seem right about that. There's really no incentive for people to care where they put their money as long as it is FDIC insured.

Also, to call the FDIC an "insurance" program is blatant misuse of the term. They should have called it the Federal Deposit Guarantee Corporation. I've never heard of an insurance company that rarely if ever collects premiums from those they insure. Does the FDIC even employ an actuaries?

[Michael]

I've never heard of an insurance company that rarely if ever collects premiums from those they insure. Does the FDIC even employ an actuaries?
:rofl:

Can you imagine what the premiums really ought to be, if one factors in the cost of all the bank bailouts onto the FDIC books and actually applied standard actuarial principles to them? Those fat premiums would go a long way towards paying off the public debts being incurred right now to finance the bailouts!

But that would actually apply 'real' market principles and we can't have none of that! :rolleyes:

- Actually, now that I think about it, this is exactly the kind of cyclical 'tax' on banks and financial companies that is needed. Let the price of the premium ride on the value of the bank profits. That will fatten the kitty when times are good (and will drop the 'cost' when times are bad, but still have a huge pot of money to pay for the bad times crashes).

[Michael]

How about "mark-to-market" accounting rules being relaxed? :eek:

I think this is insane for several reasons.

1. Present rules apply to everyone equally. They are clear and transparent. Everyone knows the game. With the new rules, banks can use their own internal models to evaluate the value of assets they hold on their books. Each bank can do this differently (and will keep their model secret) so that with this rule change, no one has a clue what is being used to evaluate the value of assets on the banks books. This rule change reduces market transparency.

2. One of the reasons the USA is the economic powerhouse that it has been is because many of the globe's smartest investors have admired the way the US economy, its rules and regulating bodies have always been ruled by the private market, not by overt political interference (as is common in almost every other country - USA has been quite unique here). However, this change of "mark-to-market" is coming indirectly via Congressional order and thus, this fundamentally pops the bubble of 'private market regulation' in the USA. It is becoming increasingly clear that the US economy is now going to be run by the government as much as this is considered normal in most other countries.

3. The financial crisis was not caused by 'mark-to-market' rules. These rules are the ones that force the banks to admit that they are as insolvent as their assets are toxic. Banks don't like this at all - go figure. Why is anyone listening to what the bankers want? They are the ones who blew trillions in bad bets on the markets and now are insolvent. Hiding bad banks with funky bank regulations is pretty much guarenteed to turn the US banking industry into the walking zombie that has characterized the Japanese banking industry for the last 15 years (note that the Japanese claimed to have three of the four largest banks in the world - just before their crash).

[Americano]

It'll be worse in the US. To even imagine the US housing industry will recover to former asset values under prudent lending standards (which seems to be the what has to be LSD-induced fantasy of relaxing fair market value asset accounting) is ridiculous. No sane investor will speculate on securities where the underlying asset value is imaginary. Other than those using public funds.

[Michael]

The Obama administration is backing away from seeking a major reduction in the number of agencies overseeing financial markets, people familiar with the matter say, suggesting that the current alphabet-soup of regulators will remain mostly intact.

....The administration, for example, is unlikely to call for merging the Commodity Futures Trading Commission and the Securities and Exchange Commission, an idea it had considered, these people say. It also isn't expected to call for the Federal Reserve, Federal Deposit Insurance Corp. or the Office of the Comptroller of the Currency to cede their primary authority to supervise banks, they say....Officials worry that trying to start from scratch could ignite messy turf battles that might slow or even derail the entire process.
Source-WSJ (http://online.wsj.com/article/SB124451579977696939.html)

I'm beginning to see a pattern here with the Obama administration and it is not a pretty one. It seems to involve 'caving in' to the opposition before the fight starts on the absurd notion that this helps to get policy passed.

Note to Obama: Caving in to the opposition on any issue means giving up on implementing good policy.

I can't say I surprised by this 'walkback'. I'm only suprised that it is this obvious and this early on a issue that hasn't even reached the mainstream yet.

This policy switch is in my mind as catastrophic as the games being played with Habeus Corpus. And we already know that the Treasury department played propaganda games with the 'stress tests' so I'm already suspicious about the future integrity of US Banking. Gaming the regulator is of course the key issue in causing this nightmare and if it isn't reformed, you can guarentee this game will be repeated soon enough.

It sure is getting hard to even given the benefit of the doubt to Obama any more. So many policy areas are on Bush-Admin-autopilot and Obama keeps reaffirming his desire to keep it that way. This is not good at all.