Banking failures: The US bank collapse ushered in the worst global recession since 1929 (for details see my article). And we are now watching banks in Europe fail (see my article). The symptoms that caused both collapses are the same: the banks bought risky assets, tried to get them insured, packaged them and then tried to sell them off. Because there were no buyers, the banks effectively became insolvent. We can’t allow this to keep happening. For details, read on.
(in bil. US$)
Source: Federal Reserve Flow of Funds
Contrast this with our concern over what private equity, hedge funds, and similar financial entities do. Most of the time, we don’t care what happens to these firms. We only care if what happens to them endangers banks/our deposits. Do you remember Long Term Capital Management? It was one of these high risk entities. Roger Lowenstein wrote a great book about what happened and why we cared. We cared because LTCM had borrowed lots of money from banks. The banks were at risk. The Fed intervened to make sure the banks did not collapse. To repeat, we care about banks because we want our deposits to be safe. I next describe how what is happening in Europe is the same as what happened in the US.
In the US, the risk instruments were mortgages. In Europe, the risk instruments are government debts (sovereign debt). In both instances, the banks bought them up. Two immediate questions come to mind:
- Why would anyone buy up mortgages when it was clear that a significant number went to people who had no chance of paying them off?
- Why would anyone buy Greek debt?
The answer to both questions is the same: banks did not buy these debts as investments. They bought them to package them and earn a commission by selling them off. And that leads to another question: how could they be sure there would be a market for them? Banks are not known for having a long-term economic perspective. They might say “there was a market for these assets today and there will be a market for them tomorrow; we have insured many of them; they got good ratings from the ratings agencies; our banks examiners have not questioned them.
But the banks were wrong, the ratings agencies were wrong, and the bank examiners were wrong, and the insurers (sometimes one bank insuring another’s assets) did not have the funds to cover the losses:
- In late 2008, the market for mortgage-backed securities vanished overnight. Panic ensued resulting in $50 trillion in financial asset losses, and a dramatic reduction in consumption and investment that caused the global recession.
- What is happening in Europe today? I quote from a recent IMF Staff Report appearing in a recent article: “Banks in Greece, Ireland and Portugal have significantly increased their government debt exposure during 2010. Shunned by financial markets and faced with deposit withdrawals, they survive only because the ECB meets in full their demands for liquidity against collateral of rapidly declining quality.” The powers that be in Europe don’t care about high unemployment. Their focus is on saving the banks. Where will the European crisis go? Who knows, it is pretty grim.
Why Do We Let Banks Engage in Such “Risky” Activities?
When I ask banking friends this question, they often talk positively about how securitization (the packaging and selling of financial assets) is good in providing additional liquidity to the system. Securitization does not increase liquidity: for every securitization transaction, there is both a buyer and seller. The most important effect of securitization is to change the focus of lenders. If lenders cannot sell off their loans, their concern focuses on the financial soundness of borrowers. If they can sell off their loans, their focus will be on making as many loans as they can to earn commissions.
Others believe that with adequate bank regulation, we can prevent future crises. I fear this is nonsense. What good have the Basel accords been? Ratings agencies? Insurance? History should tell us that we cannot anticipate the problems banks will get themselves into if left on their own.
What Should Be Done?
Depository institutions should manage their own loans. Depository institutions should not be allowed to trade for their own account. Why? Too risky. This is hardly an original observation. The Glass-Steagall Banking Act of 1933 established the Federal Deposit Insurance Company to insure deposits. It also required depository institutions to sell off their trading operations (investment banking arms) because they were too risky. In recent years, the bank lobbyists have been active. They managed to get the critical features of the Act repealed in 1999. Now, depository institutions can do just about anything.
Why Are Banks So Eager to be Able to Get in So Much Trouble?
It is simple. Their CEOs can only justify their annual compensation of $20 million+ if they make large profits from trading. If they are restricted to prudently managing the loans they make with their depositors’ money, they can’t justify their salaries.
The solution for US and European banks is the same: Government deposit insurance should only be available for banks that manage their own loans and do not trade on their own behalf.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.