No More Welfare For "Shadow Banks"
Risk your own money, fat cats.
In the WSJ, Thomas M. Hoenig, a director at the FDIC, says the FDIC and taxpayers are underwriting too much private risk-taking -- and I sure agree:
Before 1999, U.S. banking law kept banks, which are protected by a public safety net (e.g., deposit insurance), separate from broker-dealer activities, including trading and market making. However, in 1999 the law changed to permit bank holding companies to expand their activities to trading and other business lines. Similarly, broker-dealers like Bear Stearns, Lehman Brothers, Goldman Sachs and other "shadow banks" were able to use money-market funds and repos to assume a role similar to that of banks, funding long-term asset purchases with the equivalent of very short-term deposits. All were able to expand the size and complexity of their balance sheets.While these changes took place, it also became evident that large, complex institutions were considered too important to the economy to be allowed to fail. A safety net was extended beyond commercial banks to bank holding companies and broker-dealers. In the end, nobody--not managements, the market or regulators--could adequately assess and control the risks of these firms. When they foundered, banking organizations and broker-dealers inflicted enormous damage on the economy, and both received government bailouts.
To illustrate my point, consider that if you or I want to speculate on the market, we must risk our own wealth. If we think the price of an asset is going to decline, we might sell it "short," expecting to profit by buying it back more cheaply later and pocketing the difference. But if the price increases, we either invest more of our own money to cover the difference or we lose the original investment.
In contrast, a bank can readily cover its position using insured deposits or by borrowing from the Federal Reserve. Large nonbank institutions can access money-market funds or other credit because the market believes they will be bailed out. Both types of companies can even double down in an effort to stay in the game long enough to win the bet, which supersizes losses when the bet doesn't pay off. The Federal Deposit Insurance Corporation (FDIC) fund and the taxpayer are the underwriters of this private risk-taking.
...My proposal seeks to return to capitalism by confining the government's guarantee to that for which it was intended--to protect the payments system and related activities inside commercial banking. It ends the extension of the safety net's subsidy to trading, market-making and hedge-fund activities. This change will invigorate commercial banking and the broker-dealer market by encouraging more equitable and responsible competition within markets. It reduces the welfare nature of our current financial system, making it more self-reliant and more internationally competitive.
As WSJ commenter TC Phillips wrote (and this applies to GM and other corporate welfare recipients):
Too big to fail is too big.
"Before 1999, U.S. banking law kept banks, which are protected by a public safety net (e.g., deposit insurance), separate from broker-dealer activities, including trading and market making. "
Let me write this more succinctly: this is the 1930s New Deal Glass-Steagall Act, which we capitalists obliterated in 1998. Whine all you want, government regulation is *over*.
Andre Friedmann at June 11, 2012 7:01 AM
As the previous poster pointed out, bringing back Glass-Steagall would solve most of the problems mentioned.
The government could also require larger institutions to have increasing minimum capital requirements as they get larger instead of breaking them up. That way financial institutions could get as large as they want to; provided that they have enough capital to cover the negative externalities on other actors in the economy that they would produce if they suddenly and drastically failed.
Mike Hunter at June 11, 2012 9:15 AM
Any good effect of government deposit (investment) guarantees has to be balanced against the costs and the systemic bad effects. The FDIC is in trouble ( moneyteachers.org/FDIC.html ) and has cost $100+ billion from time to time above the insurance premiums which it collects from banks.
The movie "It's a Wonderful Life" is interesting.
In the bank run scene ( youtube.com/watch?v=qu2uJWSZkck ) James Stewart explains to the crowd that their money isn't really in the bank, it has been lent out to build houses. This is news to them! They thought their money was safe in the back room, and now they are told it is gone, dependent on the bank staying in business. That is reassuring.
Consider, would anyone loan money to a bank (make deposits) without the government guarantee? I wouldn't. I would find a pure vault and checking service and pay $100 per year for the service. Of course, banks might devise a private system of deposit (investment) insurance which would meet the demands of risk depositors.
One could argue, this shows that the guarantee is absolutely necessary. I say that it shows the primary instability of US banking and the fundamental fraud that keeps banks going in their current form.
If you want interest on a loan, then there is risk. Banks have transfered their risk onto the government to the extent that their FDIC premiums are not sufficient to pay for bank failures. They have transferred a lot of risk. Worse, each bank is encouraged to take excess risk both to meet political pressure and to make extra profits. Heads they win, tails we lose.
Government is not merely intermediating, that is enabling a voluntary market which might not otherwise exist. Instead, government is subsidizing an industry where the depositers are ignorant of what is going on. The depositors do not really want to "invest" their money and take risks. The bank dearly wants to make money from lending out these deposits, but does not want to bear the full costs of doing this.
So, have two types of account,
• Checking: The money is in the back room and the bank handles checks or debit cards for the depositers for a fee.
• Investment: (Dont' call it savings) The bank accepts your money on terms that match its investment portfolio and you recieve interest, dividends, gains, and losses as earned, like a mutual fund.
Under this system, everyone would get the results which they expect and there are no bank runs or bailouts. Yes, there would be much less investment through banks. The availability of capital would match the preferences of depositors, and government would not be a shadow investor commandeering resources to support a favored industry and its social planning.
Our recession was promoted by collapsing home prices and mortgage losses, after an extended period of government providing easy money and guarantees to support Fannie Mae, Freddie Mac, and the entire banking system. The government is still doing this. The bad housing policy was designed, encouraged, and required by government, mostly by Democrats.
The government's ability to issue guarantees is an unlimited, off-budget, extremely dangerous power. Guarantees were granted to Fannie Mae and Freddie Mac (among other institutions) above and below the table. They used these guarantees to borrow and lend massive capital resources. This power was used unwisely to build houses that could not be paid for. This has caused our financial crisis.
We Guarantee It - The Government Caused the Economic Crisis
Andrew_M_Garland at June 11, 2012 11:07 AM
Leave a comment