Big Banks Are Feeding Like Parasites on the Govt.'s Money
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Wall Street bankers, along with the rest of the players in the financial industry, like to think of themselves as swashbuckling capitalists. They battle cutthroat competition with one hand and oppressive government bureaucracy with the other. In reality, the financial industry is deeply dependent on the government. Far from the rugged, go-it-alone types they wish they were, they are more like well-dressed, coddled adolescents. And this is true in good times and bad.
The industry's dependency takes five main forms:
* an explicit safety net provided by government deposit insurance;
* an implicit safety net provided by "too big to fail";
* a special privilege of being the only untaxed casino;
* an open invitation to raid state and local governments for fees;
* a right to change contract terms after the fact.
These dependencies are entrenched, and, despite loud protests to the contrary, the removal of government from the financial sector is not really on the agenda. The issue up for debate is not the virtues of the free market versus government regulation. The industry wants government regulation, just not in a way that curtails its profits.
In thinking about regulation, then, we need a fuller appreciation of the industry's dependency on government. This will not tell us what to do, but it should open the
door to a debate about regulatory reform that takes up the real question: will regulation be structured in a way that advances the public interest or in a way that
allows the financial sector to profit at society's expense?
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Perhaps the most important financial reform to come out of the Great Depression was federal deposit insurance under the supervision of the Federal Deposit Insurance Corporation (FDIC). The FDIC largely protects banks from the sort of runs that led to the bank failures of that era.
Banks typically keep only a small portion of their customers' deposits on reserve, and, even then, lend most of it at interest. This practice is reasonable
because customers are unlikely to want all of their money at the same time. In fact, there may be as much money deposited as withdrawn on any given day.
But if depositors become concerned about the health of the bank, they may rush to pull money out. Those at the bank first will be able to get their money. Later
arrivals will be out of luck, as the bank's reserves will be depleted. Thus, before federal deposit insurance, runs were a logical response to the fear of bank failure.
The FDIC completely changes the logic. By insuring the bank's deposits, the FDIC eliminates the incentive for depositors to rush to withdraw their money. They know that their funds (up to the insured level) are safe.
The FDIC lent an enormous amount of stability to the system, and the benefits are shared by depositors and banks alike. However, government insurance means that the market does not offer the normal discipline against risky behavior. Typically, a bank making high-risk loans must offer high interest rates in order to assuage wary depositors. But if the bank has government insurance, depositors need not worry about losing their money thanks to others' unpaid loans. Thus, insurance allows the bank to attract deposits at relatively low interest rates and still incur high risk on loans. If a bank is in financial trouble and has little of its own capital at stake, the incentive to take large risks is even greater. And its customers, who are covered by deposit insurance, have no reason to be concerned about the soundness of a bank, even if the bank ends up suffering large losses and going out of business.
The government, as the insurer, must actively regulate insured institutions so that they do not take advantage of FDIC protection. The response to the Savings and
Loans (S&Ls) crisis in the 1980s is a textbook example of what can happen when the government ignores this regulatory responsibility. Heading into that decade,
thousands of S&Ls were essentially insolvent. Instead of shutting them down-the customary response to insolvent banks-the Reagan administration encouraged them to earn their way back to solvency. Many, logically, took large risks with insured deposits. In fact, they flaunted their access to deposit insurance by offering higher interest than their competitors in order to attract more money and grow more quickly. As a result, losses more than quadrupled over the decade, eventually costing taxpayers more than $120 billion ($190 billion in current dollars).
The story of the S&Ls is not a free-market one. Banks were exploiting the deposit insurance system. The lesson is simple: if the government insures the bank's
deposits, then it must also regulate the bank. Where the government grants insurance without oversight, banks take big risks at taxpayers' expense.
In addition to monitoring risk-taking at FDIC-insured banks, the government is required to enforce minimum capital-reserve requirements. Together, these safeguards ensure that the banks' shareholders will suffer the first losses. Only then will shareholders try to prevent the bank from making overly risky bets.
Maintaining a minimum level of capital is a difficult regulatory task. At any given time, banks have a wide variety of loans on their books. Some of these loans may
be worth only a fraction of their original value, as is the case with many commercial and residential mortgages today. In principle, banks should mark these loans down to their true value so that their books represent ongoing profitability accurately and balance sheets reflect true net worth. However, banks have little
incentive to write down a bad loan before absolutely necessary-showing a loss on their books is bad for stock prices and executive bonuses. Delaying write-downs also allows banks to misrepresent their capital position. If a bank has losses equal to 10 percent of its assets (the standard capital reserve requirement), then it has no real capital, since an accurate accounting would show that the loan losses wipe out their capital.
Only if regulators oversee banks' behavior on an ongoing basis will banks disclose the true value of their bad loans. Otherwise, they will have too much incentive to hide their financial condition.
An insured bank must be a regulated bank; there is no way around this. An unregulated bank with government insurance has a license to rip off taxpayers, and
unfortunately many banks have done precisely that. In particular, recent rule changes that allow banks to use "fair value" accounting instead of market accounting in assessing the value of their assets enable banks to bury large losses.
Some argue that because deposit insurance is paid for by banks it is not a subsidy and thus does not require oversight. This is true in normal times, although not in the extreme cases like the S&L crisis, and quite likely will not prove to be completely true in the current crisis. But even in normal times, when FDIC insurance
does not act as a subsidy, the system needs regulation. If the government backed off regulation while still offering insurance, as it did with the S&Ls and is doing
to some extent now in allowing fair-value accounting, the losses and therefore the cost of the insurance would skyrocket. The low-risk actors in the industry would
bear the costs of the risky behavior of others and, in the end, the system of insurance become unworkable, as happened with the S&Ls.
Even if deposit insurance is privately provided, as is the case in some countries, government involvement is still necessary. Any insurance system that covers a
large share of a country's deposits has the implicit backing of the national government in the event of a crisis. No one would believe that the government would
let a private insurer collapse if the simultaneous failure of many banks left it insolvent. The private insurer would be acting with an implicit government guarantee. This guarantee would entail regulation in order to prevent abuse.
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FDIC offers banks an explicit safety net. Several large institutions also enjoy an implicit safety net because they are "too big to fail" (TBTF). This safety net allows them to borrow money (other than insured deposits) at a lower interest rate than would otherwise be the case because lenders know that the government will back up the institutions' loans if necessary.
The implicit TBTF guarantee has become explicit in the current crisis: the government stepped in to back up debts to creditors when Bear Stearns, Fannie Mae,
Freddie Mac, and AIG became insolvent. The government had no legal obligation to honor any of the debts incurred by these companies. It justified the intervention by claiming that failure to act would cause serious damage to the financial system and the economy.
The TBTF guarantee extends well beyond this list of failed institutions. Citigroup and Bank of America would almost certainly have faced insolvency had it not been for the extraordinary measures taken by the government to support them in late 2008 and early 2009. Their status even now is questionable, with both banks operating with government guarantees for hundreds of billions of dollars of bad assets. The 2008 Troubled Asset Relief Program (TARP), coupled with access to a special FDIC loan-guarantee program and Federal Reserve lending facilities, kept several other large and troubled financial institutions alive through the worst months of the financial crisis.
In other words, the implicit TBTF guarantee is real. After it allowed the huge investment bank Lehman Brothers to collapse, the government virtually promised
that it would not allow another major financial institution to fail. Other large financial institutions took the promise seriously.
What is wrong with that? Because lenders knew that their loans to Goldman Sachs, Citigroup, Morgan Stanley, and other giants were effectively backed by the government, they offered these companies substantially lower interest rates than they offered smaller banks. While large financial institutions are always able to get funds at a somewhat lower cost than smaller institutions, the gap in the cost of funds between small and large banks grew by half a percentage point following the collapse of Lehman. Multiplied by the assets of these institutions, the increase amounts to a $33 billion-a-year subsidy at the expense of small
There is no reason to allow banks to reach the size of the TBTF institutions. Research on size and efficiency in the banking sector usually shows that all economies of scale can be fully realized at around $50 billion in assets-Bank of America and J.P. Morgan Chase have more than $2 trillion. That banks in the United States and elsewhere have grown so large may be an indication of the benefits of greater market power, political power, and, of course, the advantage of the TBTF subsidy itself.
Subsidizing the largest financial institutions to the detriment of their smaller competitors is not a free-market policy. Two options could restore the balance: break up the large banks so that they are not recognized as TBTF, or impose regulatory penalties, such as larger reserve requirements, that roughly offset the benefits
of the TBTF guarantee. If some banks voluntarily break themselves up into smaller units to avoid the penalty, then we will know that the penalties are comparable in size to the implicit subsidy of TBTF.
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Suppose the state of Nevada waived the 6.75 percent tax on gambling revenues for one casino in Las Vegas. That casino could promise better odds than its competitors and still have a larger profit margin. Wall Street financial institutions essentially enjoy this kind of advantage: they can profit from gambling opportunities unencumbered by the taxes paid on other forms of gambling.
Not all investment is gambling, of course, but most short-term trades, which comprise the vast majority of trading volume, are comparable. The payoff on a bet on
an oil future or credit default swap is, to a large extent, random. Research may help Wall Street traders make informed bets, but it helps serious gamblers at the
horse races too. A gambler who knows the stakes is still a gambler. Yet the racetrack gambler will pay 3-6 percent in taxes on her bet, and the Wall Street gambler pays none.
I use the term "gambling" seriously. Gambling may have a financial upside for the gambler, but it provides no benefit to the economy. If the gambler is successful-- as a skilled poker player may be-- he is simply taking wealth from others, not adding wealth to the economy. Short-term financial gains are similar.
A long-term investor, however, can rightfully claim that he is providing capital to businesses that increase societal wealth. And a successful long-term investor,
such as Warren Buffet, can point to many cases in which his capital allowed companies to grow. These companies presumably provide goods and services valued by society and create jobs. Of course, there are cases in which a company's growth may not be beneficial to society on the whole, but the point remains that long-term investment has the potential to benefit the economy by creating wealth.
Short-term speculation is unlikely to have this effect. For example, if a speculator correctly bets that oil futures will rise in price, she will have captured some of the gain that would have otherwise gone to the producer, which could have sold its product at a higher price. The speculator will probably also have imposed some cost on the purchaser (either an end user or another speculator) who will likely have to pay a higher price in the future than if the speculator had not been an actor in the market.
Speculators can help stabilize markets by forcing prices to adjust more quickly. But "noise traders," who act largely on rumors and focus on anticipating the behavior of other actors rather than fundamentals of supply and demand, impose a cost to the economy by moving prices away from the levels that the fundamentals suggest, thereby destabilizing markets. They make markets give out the wrong signals. If ungrounded speculation drives up a price for oil futures, oil producers might initiate drilling in areas where they will not be able to cover the extraction cost when oil prices return to a non-inflated level. The oil companies will incur losses, and the economy as a whole will suffer a waste of resources.
Distinguishing noise trading from trades based on an assessment of fundamentals is not simple. But, as a general rule, short-term trades fall into the noise
trading category more often than do longer-term trades.