The constant creation and destruction of companies, industries, and ideas is a force known as creative destruction and is a cornerstone of capitalism. Without the risk of failures like bankruptcy, where is the incentive to work harder, to develop a better product, to improve efficiency, to take chances? Bankruptcy also provides another important function: it frees up capital and talent to pursue better opportunities. Think of Google's parabolic growth over the past eight years. How many of those new employees were from companies that had failed when the dot-com bubble burst? Would there have been money to fund the next round of companies like YouTube or Facebook if venture capitalists had not allowed many of their earlier investments to fail, instead of continually throwing good money after bad?
Which brings us to the real question: if these naturally occurring forces have proven themselves effective so many times across multiple industries, decades and centuries, why do we fight it so defiantly when it comes to banks? The obvious answer is that banks are different because we as consumers have our money there. If a Silicon Valley startup files for bankruptcy, the only likely losers are their ostensibly wealthy investors, and possibly their lunch catering company. However, when a bank fails, the potential losers are every depositor in the bank, as was demonstrated during the Great Depression. The federal government tried to alleviate this fear by creating the FDIC which acts as "insurance" for bank customers against a possible bankruptcy. This worked for awhile until a combination of deregulation and increased bank mergers led to the rise of huge behemoths whose total deposits far exceed the FDIC's or anyone's ability to insure them.
All successful insurance models are based on the theory that the maximum size of any individual claim is a tiny fraction of the money available, and the odds of a large percentage of clients filing claims at the same time is very, very small. Auto insurers spread their risk through millions of car policies across the country and no single claim from any client can have a large impact on their overall reserves.
Recent numbers from the FDIC suggest that it currently has approximately $55 billion on hand. The FDIC also has lines of credit with the Treasury department for situations where its cash on hand proves inadequate. This all sounds well and good until you look at what it's charged with insuring. By its own math, The FDIC estimates that the $55 billion of reserves is insuring $4.4 trillion in deposits, a 1.25% ratio. The problem with this is not the ratio of reserves; it's the distribution of deposits. Bank of America, as an example, currently has more than $600 billion in deposits. That exceeds 10x the amount the FDIC currently has and more than the US government has injected into the entire banking system to date. The 6 largest banks by deposits have over $2 trillion in combined deposits, almost 50% of the total of the country's bank deposits.
As if this weren't enough, these same 6 banks have issued mountains of debt, thus amplifying any potential bankruptcy across the financial system and potentially leading to a complete banking system collapse. This is the definition of "too big to fail".
And that brings us to our current situation; we have created these monsters which require constant care and feeding in the form of taxpayer's dollars. If we don't take care of them, they can destroy our entire economy. What we don't appear to understand yet is that no amount of money, time or regulation can possibly resolve this problem while these few banks continue to hold the entire nation hostage. Even if the economy turns, housing prices rise and companies begin hiring again, we cannot have a robust financial system until these leviathans are no more. Unfortunately, government action to date has only exacerbated the situation. A combination of forced mergers and poorly structured government capital infusions has led the US taxpayers to contribute $45 billion in cash to one banking institution while guaranteeing $98 billion in potential loan losses. What do we get in return for our money? Not much of value; that gives us a 6% stake in Bank of America, whose entire market capitalization was only $36 billion as of Friday.
These banks need to be broken up and a clause added to the FDIC requirements to prevent banks from participating in the FDIC program if their total deposits exceed a certain ratio of the FDIC's available funds. This will have the dual impact of creating a far more diverse set of banks with many more competing ideas and business models. The FDIC will also be left with ample funds to cover individual bank failures and restart the critical process of creative destruction. I look forward to the day when the media has to the same shocked reaction to the failure of a bank that made bad lending decisions as they did when Pets.com went bankrupt by blowing a large portion of their funding on sock puppets and super bowl ads.
Standerfer is the Executive Vice President of Financial Services for S3, an Austin, Texas company that manages trading information for most of the country's major financial services firms.
- Incentivize correct risk pricing - e.g. Denmark's mortgage scheme that ties a mortgage originator to the original loan's payments. Charge appropriate rates for FDIC insurance.
2) Banks are crying for suspension of mark-to-market rules. Do not give in but also understand that some of the instruments banks are holding are tough to price and sell currently. Letting them sit in a bad asset pool, allowing the market find its footing and appropriate liquidity appear may be a good long term strategy to extract the most value for taxpayers.
Long story short - the small or smaller bank idea is one worth mulling over and could work, at least in the short term. But if the real aim is to understand what our institutions are up to and what kind of risks they're taking, we should be less focused on their size then on risk regulating them appropriately.
Sources/links of interest:
On the FDIC: http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3605
http://www.economist.com/finance/displaystory.cfm?story_id=12342681&CFID=39899027&CFTOKEN=99936109
On human nature (not the Wilson book :-)) and why Wall Street Always Blows it: http://www.theatlantic.com/doc/200812/blodget-wall-street
Denmark, mortgages and correct risk incentives: http://www.economist.com/finance/displaystory.cfm?story_id=12855447
GMO Report from Jeremy Grantham on Japan and their handling of the crisis: http://www.gmo.com/websitecontent/JGLetter_4Q08.pdf
Some thoughts:
- On the too big to fail and the role of the FDIC as a small ship valiantly fighting against a surging tsunami of potential claims:
1) The FDIC charges a flat fee premium for its insurance services and the reserve ratio Standerfer mentions is set by Congress. An actuarially fair rate charged to banks based on their relative risk, would likely be far higher (i.e. adequate to cover far more than what we're likely seeing right now). Did you know that the FDIC only collects fees from 5% of insured banks?
- On pricing risk appropriately and regulation:
1) Financial failures and bank recapitalizations have been happening all over the globe for the last 30 years. We don't need to reinvent the wheel (not totally at least). Experiences in Japan, Sweden, Turkey and Argentina are valuable for seeing what can be done here in the United States. Policy prescriptions from these countries appear to fall into the following rough categories:
- Create a "bad" bank asset pool - we did this with the S&L crisis, which was far smaller admittedly, as did the Japanese and the Swedes.
- Create regulatory limits and firewalls around banks - include higher reserve ratios during good times and lower ones during bad times. Limit the types of instruments banks can deal in (i.e. nothing esoteric that an SEC regulator can't understand)
Good post and definite food for thought. Unfortunately, some of the prescriptions go against what I would term as human nature and the system of capitalism we've set up here. Standerfer, being from Texas where everything is bigger and better (right? :-)), should know that companies, like people, want to grow and do grow. We've been "arriving" to this current state over the past 70 years as companies (including banks) merge, de-merge, go bankrupt, reorganize etc. There are simply a lot of efficiencies and conveniences that come from being "big", along with, as we're clearly seeing right now, a lot of risks. As a comparison, there are many large or national banks in many other countries with banking systems similar to ours who did not need a bailing out.
The real issue here (and God knows there are many of them), is the correct pricing of risk and the subsequent regulation. I would say that rather than focusing on size, what we should be focusing on is the types of risks we allow our financial institutions to take and then regulating them appropriately - a test we have failed.
We need to look at the problem a little differently than what's being espoused here (although I will not go as far to say that it is necessarily a terrible policy direction - it will reduce risk in the short term but but long term I do believe it ignores how we behave as a liberal, capitalist democracy).
Attempt to ply your ideas in a notable publication in thie Country. Let me know when you are published.
Quality of life may be enhanced by the perception of stability. Creative destruction does not promote the perception of stability.
Creative Destruction was the operative philosophy while wages did not grow and the middle class stressed. Creative Destruction may not be an optimal policy choice.
The FDIC should immediately forgive all loans that the failing banks were holding and immediately put millions back into the economy without borrowing more money. Banks are getting the deposits to make more loans with. They should not also be allowed to buy the good loans for pennies on the dollar and keep the economy in debt. All of the money the economy exists on is borrowed and the debt has to be reduced.
http://ewebsmith.com/Finance/economicproblem.html
As for your proposed solution... everyone is apparently entitled to an opinion and in this environment, know one knows the right solution.
What the heck would that do to the dollar? How can you just wipe out trillions of dollars and still attract foreign investment? I'm not being critical, just curious.
1. Federal Reserve, a private institution, owned by 12 regional FED banks, each in turn owned by regional, commercial, and foreign banks, and inherited by individuals. (Rockefellers, Rothschilds..)
2. FED holds monopoly on issuing Dollars and can borrow infinite amounts of money at 0% to purchase income-producing assets. Before TARP, only assets purchased were Treasury debt.
3. Dollars created are debts, principals due. Money to pay principal is printed in the future causing inflation.
4. Prior to TARP, commercial banks had to hold 10% of deposits in FED as reserves putting limit on money creation at 9x deposits. Hidden TARP clause dropped reserve required from 10% to 0%, so FED could create infinite Dollars.
5. Credit spread blowups in October/November 2008 were because TARP allowed FED to hide the interest rate paid on deposits! Before TARP, around $20 billion was deposited by banks in FED, but after TARP deposits jumped 50x to $1 TRILLION, causing demand for risky assets to evaporate, and credit spreads blew up.
6. TARP/Congressional actions gave FED authority to buy any assets, and seize all valuable assets in USA for green paper without Government approval for money or debts.
7. Much of FED’s activity is kept secret using “off-balance sheet” accounting, illegal in many countries.
8. The Constitutionality of Fed's awesome powers is under Debate.
http://seekingalpha.com/article/115275-8-important-facts-about-the-federal-reserve
The planet is finite.
Cool. Let's do it.
(Pipe Dream) soon...you can write the end of this story.
How can anyone make a decision with their money on anything when such manipulation is possible?
Such behavior lends economic benefit only to those who are insiders with the Fed or have studied the various devices the Fed uses to manipulate our economy.
I can't see how anyone could describe our economy as a 'free market' when the Fed has this power.
Does anyone else think that interest rates should be set by agreement between the borrower and lender instead of by fiat?
The fact that the supposed purpose of the Fed from the mouths of its designers was to prevent a tyranny of bank failures is turned on its head by recent events and the fact stated in this article that FDIC banks are only 1% solvent.
How is it that we can expect a free market when the people of this country have no say in the matter of whether or not the Fed will decide to finance a new program by Congress for which they have not allocated taxes?
Is the Fed not stealing from the poorest among us as they finance Congressional spending by merely printing up the currency to pay for it, thereby decreasing the value of every existing dollar?