Jump to content
Objectivism Online Forum

Potential solution to banking crisis

Rate this topic


solution checker
 Share

Recommended Posts

Hey guys,

I have this idea how to prevent a new banking crisis, and I'd appreciate your opinions on it.

It's very simple.

I think a flaw in the current banking system is that bankers get huge bonuses when they are doing well, and they loose nothing of their own when they are failing dramatically. As a result, they will take a lot of risks, similar to what you would do if you go to a casino with an unlimited amount of money, and you get to keep a part of the profits, but you don't have to pay for the losses.

The opposite of a Bonus is a Malus. My suggestion is to make a law, that states the following:

"The right to get a bonus for exceptional good financial results implies the duty to pay a malus for exceptionally bad financial results."

With this law, naturally the bank management (and anyone else potentially entitled to a bonus) will put far more effort in checking that non of their employees is taking too much risk, and that a lot of checks and balances are in place. This would then result in a far more stable bank, focusing more on the long term stability and less on the short term profits. As a result banks won't go bankrupt as easily, and tax payers money won't be needed for saving banks that took too much risk.

What do you guys think, would a law like that be able to help in preventing a new banking crisis? Thanks for your opinions!

Link to comment
Share on other sites

Hey guys,

I have this idea how to prevent a new banking crisis, and I'd appreciate your opinions on it.

It's very simple.

Most good ideas are simple. However, they are the result of their author first understanding all the complexities of a problem, and then finding an elegant way to solve it.

That's not what you're doing. You just wrote down the first thing that popped into your head, without understanding the problem. Your idea is simplistic, not simple.

First, understand the problem, then you'll figure out what the simple solution is to the problem (what the simplest way is to eliminate the source of the problem). Hint: the solution is much more simple, in fact, than what you are proposing. You're even on the right track, now you just need to figure out why banking is like walking into a casino with other people's money, and nothing to lose.

Has banking always been that? Or has something changed over the years?

Edited by Nicky
Link to comment
Share on other sites

Most good ideas are simple. However, they are the result of their author first understanding all the complexities of a problem, and then finding an elegant way to solve it.

Hi Nicky, thanks for your comments. However, it would be helpful if you would not leave me guessing, by clarifying your opinion. Do you think it's a good solution? My impression is you don't (too simplistic) but you also say I'm on the right track. Could you explain why you think it is or is not a good solution? Could you propose your better / simpler solution?

Thanks!

Link to comment
Share on other sites

... ... but you also say I'm on the right track.
You are on the right track to this extent: if managers have more skin in the game, some of them would act more responsibly. Having skin in the game could work to some extent, but it is only one concrete among many others. The part you get wrong is in wanting this concrete negative bonus mandated by law.

Banking is in its current state because of various such government-mandated "solutions" that have been thrown at it over decades. For instance, there was a time when bank directors had unlimited liability for the debts of the bank. There was a time when the notes of a not-so-good bank would only be accepted by another bank at a discount (i.e. they would refuse to pay face value). There was a time when customers thought about whether a bank was secure before they put their money in it. All this has disappeared because of government "solutions".

(Aside: Many hedge funds have deals with their investors so that the hedge fund has to make up losses taken in a down year before they can get a commission the next year.)

The real killer of safe banks has been the FDIC. There was a time when some banks were super-secure. A few top-notch New York banks kept nearly 100% reserves, performing primarily a custodial function! There have been bank runs throughout the history of banking, but all banks were never equal. An important player in banking is the individual customer. The FDIC removed any incentive for the individual customer to think about the riskiness of his bank. If one bank offers me 0.25% more on a CD than another bank, it makes sense for me to put my money there. If the bank is FDIC insured, I don't care whether that bank's directors are smoking my money: if something goes wrong, the FDIC will pay me my money back.

The consequence of this is that a safer bank cannot afford its high-quality. Being high quality means that it cannot pay out as high an interest rate to its depositors, and they would desert. Over a few decades, there were no ultra-safe banks any more: they had all changed in order to survive in the new system.

Each time there is a financial crisis, people on both sides learn. This learning would typically reduce the chance of another crisis. Instead, the government steps in and creates some rule that either disallows certain types of risk taking, or mandate rules that the actors ought to be coming up with, or simply socializes the risks.

Edited by softwareNerd
Link to comment
Share on other sites

You are on the right track to this extent: if managers have more skin in the game, some of them would act more responsibly. Having skin in the game could work to some extent, but it is only one concrete among many others. The part you get wrong is in wanting this concrete negative bonus mandated by law.

Hi sNerd, thank you too for your comments. You obviously know a lot about the banking system. However, I don't really follow your arguments.

1. First you state a few government-mandated solutions in history that were only partially successful. I do not attack or defend anything that happened in the past, and I don't think these measures say anything about the quality of my proposed solution, so why is MY solution wrong?

2. Your point about the FDIC. I have a simple solution for that as well. The FDIC should not pay 100% back, but only 95% in case of a bankruptcy. This will make clients search for a high-quality safe bank again, and not focus on interest rates alone.

One last question, if you would be president, would you change anything in the banking system?

P.S. "that the actors ought to be coming up with" says it all: They SHOULD, but they DON'T, that my argument for making a law.

Edited by solution checker
Link to comment
Share on other sites

P.S. "that the actors ought to be coming up with" says it all: They SHOULD, but they DON'T, that my argument for making a law.
People do come up with solutions. They have constantly done so, through history. The biggest reason they don't is that the government comes in with some rule that relieves them (temporarily) of any incentive to doing so.

1. First you state a few government-mandated solutions in history that were only partially successful. I do not attack or defend anything that happened in the past, and I don't think these measures say anything about the quality of my proposed solution, so why is MY solution wrong?
It is not that those government solutions were only partially successful, it is that they are the primary cause of today's problems. As for your solution, as I noted in my post, it might be valid as a clause that bank-owners (i.e. shareholders) might put into their contracts with bank-directors and CEOs, it might be valid as a clause that bank-depositors insist upon. However, if they do not think it is the right clause, they should be free to decide otherwise. It is wrong for the government to come in and tell an owner what type of deal that owner has to impose upon his managers. It is exactly this government-driven approach that has brought us to this pass.

If I were president...? Well, the ideal banking system would be one in which bank-owners, bank-managers and bank-depositors were free to come up with contracts that make sense to them. If I could wave a magic wand, we would roll back government controls until we have such a system. The role of the government would be to protect the sanctity of such contracts and punish fraud.

Link to comment
Share on other sites

Hi Nicky, thanks for your comments. However, it would be helpful if you would not leave me guessing, by clarifying your opinion. Do you think it's a good solution? My impression is you don't (too simplistic) but you also say I'm on the right track. Could you explain why you think it is or is not a good solution? Could you propose your better / simpler solution?

Thanks!

Well, like I said, the solution is simple: get the government out of the business of creating money, and then stop regulating the financial sector.

However, discovering that solution isn't simple. It would take books to describe everything that's wrong with the financial industry today, and how those problems are the result of government action or regulation.

I see SN attempted to get into that. The reason why I didn't is because I'm used to what happens next: and endless back and forth in which I attempt to give brief explanations and the other party, without bothering to look into things deeper, attempts to deconstruct my points. Mostly successfully, because, like I said, it would take books to prove those points to someone not already familiar with the problems (books that have already been written, and are available to anyone interested enough).

Anything less is just an attempt to point someone in the right direction. And pointing you in the right direction really doesn't require giving you the conclusion. That's why I didn't. You're in the right direction when pointing out that banking often involves "going into a casino while being unable to lose". However, you haven't even tried to identify why that is, and where the money comes from to cover those losses instead of the people taking the risks. Punishing bank managers would not be an adequate solution to that problem, because it runs much deeper than you think (politicians, central bankers, and clients of banks are all subject to the same exact distortion of the free market: they are all gambling in a casino where they can't lose, not just bank managers - in fact, bank managers are the only ones with at least something to lose: their jobs).

I don't think these measures say anything about the quality of my proposed solution, so why is MY solution wrong?

I definitely answered that question in my previous post. Your solution is wrong because you haven't identified the problem. Without fully understanding a problem, providing a solution is just guessing.

You are committing the same epistemological error most of the people currently "fixing" the economy are committing: instead of proving that your solution will work (which, again, would require understanding a very complex system and its problems), you're placing the burden of proof on others to prove you wrong. Meanwhile, you're suggesting going ahead with your solution, until it proves wrong by causing massive damage to people who never agreed to be subject to your experiment.

If you want to experiment, feel free to start your own bank (well, ask for permission to start it, actually), and give "maluses" to whoever is willing to work for you. Then, if it works, other banks might follow your example. If it fails, it affects only willing participants.

Link to comment
Share on other sites

Your point about the FDIC. I have a simple solution for that as well. The FDIC should not pay 100% back, but only 95% in case of a bankruptcy.

That's not a solution to the problem you so correctly identified. If I went into a casino knowing that I could only lose 5% of the money I was betting, I'd be gambling just as wildly as I was back when I couldn't lose anything.

In fact, if I went in knowing that I could lose 98% of my money, I'd still make a nice living out of playing standard Vegas blackjack (no card counting). It would have to take being able to lose all my money before it became unfeasible for me to play blackjack at a casino.

Playing blackjack at a casino is the perfect example of a borderline bad use of one's money, that should not be made unless you gain a small advantage. Card counting (which is a strategy that WILL deliver a profit) amounts to about a 1 percentage point edge over the house. A government guaranteeing just 2% of your money would be the equivalent of that. Now imagine what your idea, of guaranteeing 95% would do.

Link to comment
Share on other sites

Well, like I said, the solution is simple: get the government out of the business of creating money, and then stop regulating the financial sector.

Actually you didn't say this in your first post. But thanks for clarifying this. I think know enough about the history of the financial system to have some reasons to disagree with you, but I assume you don't mind I'm not getting into this.

I definitely answered that question in my previous post. Your solution is wrong because you haven't identified the problem. Without fully understanding a problem, providing a solution is just guessing.

I was asking people for reasons why they think I guess wrong. I'm not forcing anyone to reply to my request, nor am I forcing people to participate in an 'experiment'.

Edited by solution checker
Link to comment
Share on other sites

I think know enough about the history of the financial system to have some reasons to disagree with you, but I assume you don't mind I'm not getting into this.
Well, if you don't wish to discuss the true causes of the latest financial crisis, then it is really impossible to argue for your "solution".

Anyhow, government can always regulate in ways that drastically reduce the amount of risk taking. Maybe every surgeon who tries a new procedure on a patient and fails should go to jail even if he has fully informed the patient about the risks. Similarly in banking, one can have laws that stop loans that you -- the bureaucrat -- consider to be risky, even if the banker does not think it is so. You could regulate yourself all the way back to North Korea -- they don't have financial crises!

Your "solution" is attempting to solve something that is not the problem. All it will do is add to the real, underlying problem, which is: forcing other people to act in ways that you think are reasonable.

Edited by softwareNerd
Link to comment
Share on other sites

I'll give a short background of the idea to clarify it.

When a normal company goes bankrupt, it's clients go to a competitor. Therefore I think normal companies should be free in how they run their business (within the boundaries of the law and ethics). But when a bank goes bankrupt, it's clients or the FDIC / TAX payer loose a lot of money, and I don't think that's fair. This puts banks in a unique position. That's why I think there should be some kind of regulation, but as little as possible. Because I think bank employees are better at understanding risks then the government, I think it's best to leave this to the banks themselves. But to prevent a bank from going down and taking a lot of tax payers money with them, I suggested my solution.

Another potential solution would be to force banks to pay for their own bankruptcy insurance, so it's no longer the taxpayers money that's at stake. However, surely this bank insurance organization will demand certain safety standards from the banks, similar to fire-insurance companies demanding safety standards, so they won't escape regulation with this solution either (I even presume the amount of regulation the insurance will demand will be a lot higher than in my proposed solution, that's why it's not my first choice).

Other solutions in which it's not the taxpayers money that's at stake in case of a bankruptcy are welcome.

Edited by solution checker
Link to comment
Share on other sites

But when a bank goes bankrupt, it's clients or the FDIC / TAX payer loose a lot of money, and I don't think that's fair. This puts banks in a unique position.
Tax payers are the ones who put banks in that position: well, voters, to be precise. So, the people ultimately responsible are the voters. Of course, if the tax-payers are going to underwrite the banks, it makes sense -- in that context -- to stop banks from taking certain risks. However, the real solution is that voters should not be in the business of underwriting banks.

In the context of tax-payer underwriting, many restrictions in the Glass-Steagall act made sense. Robert Rubin (Clinton days) and others pushed to "de-regulate", but -- very conveniently -- they removed the regulations that kept a lid on some risks, while keeping in place the tax-payer under-writing. Then, Rubin moved on to join a private sector bank, getting paid over $100 million. Rubin's bank was one of the few major banks that stretched things beyond what was reasonable. Then, tax-payers bailed his ban out and he moved on to advise other with his expertise in how to fleece the tax-payer.

I can well understand that one looks at this and says that Robert Rubin should return any money he ever received from that bank, and that he should be fined...if not be sent to jail. It is an understandable reaction, but the real solution is that the government should not be able to use tax-payer money to underwrite risk in the first place.

Another potential solution would be to force banks to pay for their own bankruptcy insurance, so it's no longer the taxpayers money that's at stake.
Exactly. This is the correct direction. Banks can either get private insurance, or no insurance at all.

However, surely this bank insurance organization will demand certain safety standards from the banks, similar to fire-insurance companies demanding safety standards, so they won't escape regulation with this solution either (I even presume the amount of regulation the insurance will demand will be a lot higher than in my proposed solution, that's why it's not my first choice).
In theory it sounds equivalent. That's what the communists thought too: they can simply take over the means of production and everyone would make decisions the way they used to, and their country would end up with just as much wealth... simply more equitably distributed.

This ignores the most important fact: that business is changing all the time. There's no book that tells you how to arrange all the concretes. The winning and the losing and the bankruptcy is not a necessary evil, it is the essence of the process. Historian Niall Ferguson points to evolution as an analogy. Different mutations happen. Some succeed, others fail. Success implies propagation. In human actions, the "mutations" aren't random, but the rest of the analogy holds. Any attempt to freeze some governmental solution as being the one right solution is a poor recipe for success.

Further, there are value judgement involved in most human actions. When a government imposed one type of concrete action, then they also impose their values. This is immoral. If I want to take some risk that the government thinks I ought not to take, then it is immoral for them to stop me.

The essential problem with your solution is *not* that managers should not have penalties written into their contracts. The essential problem is that nothing about these contracts should be mandated by law.

Link to comment
Share on other sites

Tax payers are the ones who put banks in that position: well, voters, to be precise. So, the people ultimately responsible are the voters.

You could put the responsibility all the way down the line to Adam/Eve/God/Evolution whatever, but I disagree. I think during the voting process voters put both the power and the responsibility in the hands of the politicians, asking them to use it wisely and preferably in favor of the voters.

The winning and the losing and the bankruptcy is not a necessary evil, it is the essence of the process.

I agree. But like I said, there's nothing wrong with bankruptcy with normal companies, just with banks, because innocent people have to suffer the consequences when a bank goes bankrupt.

The essential problem with your solution is *not* that managers should not have penalties written into their contracts. The essential problem is that nothing about these contracts should be mandated by law.

You guys seem pretty serious about not wanting any influence from the government into business. Personally, I'm happy that the government checks if the kitchen in clean, the food is fresh and the fridge is working in any restaurant I eat, so I don't have to, and that the products I buy in the supermarket are pretty safe to use or consume, and that financial products from banks are checked so that they don't just steal my money and lie about the risks. You and me might be smart enough to understand some financial products and the risks, but many other people aren't, so I'm in favor of some laws that cover the bare essentials of safety and honesty (too bad they fail too often, but that's another story). I'm fine though with special banks for people who consciously want to take a lot of extra risks with an absolute minimum of governmental control, but these should be exceptions, not the standard.

Edited by solution checker
Link to comment
Share on other sites

You could put the responsibility all the way down the line to Adam/Eve/God/Evolution whatever, ...
Adam? Eve? God? I assume you meant that' as empty polemic which should be ignored. If you were trying to make a real point, clarify.

I think during the voting process voters put both the power and the responsibility in the hands of the politicians, asking them to use it wisely and preferably in favor of the voters.
if voters asked politicians to do one thing, and the politicians did something else, then one could blame politicians. One would still have to ask why voters keep returning similar politicians to power. The politicians in the U.S. represent the views of voters pretty well -- if one looks at it as a broad average. Take an example where a law was opposed pretty widely. The Obamacare law passed because a lot of voters are for it. Even those who oppose it as a whole, like many of its components. Even hard-core GOP neo-cons would design a law that is almost identical.

When FDR first ran for re-election in 1936, post NRA and other sweeping government controls , he won a resounding victory. Voters have repeatedly shown that they are for regulation, for taxing the rich, for redistribution, etc. the laws we have in the U.S. are definitely not the result of rogue politicians doing things that voters dislike. Those are exceptions. of course, voters themselves are divided, so the laws shift slightly this way and slightly the other way. However, even all this swaying simply represents the shifting views of the majority. Politicians in western democracies are pretty much representative of their voters... they act as agents.

There is a small minority who can genuinely claim that they are not responsible for the politicians. The overwhelming majority cannot: that majority gets exactly the laws they deserve.

I agree. But like I said, there's nothing wrong with bankruptcy with normal companies, just with banks, because innocent people have to suffer the consequences when a bank goes bankrupt.
This is simply false. Depositors lend their money to banks and so they lose; but, lenders lose in every bankruptcy. If GM had gone bankrupt, a lot of people would have been hurt in all sorts of ways.

It is wrong to force the unhurt to cough up money to pay for those who have been hurt. That is wealth-redistribution like any other. It is immoral for the same reasons.

You guys seem pretty serious about not wanting any influence from the government into business. Personally, I'm happy that the government checks if the kitchen in clean, the food is fresh and the fridge is working in any restaurant I eat, so I don't have to, and that the products I buy in the supermarket are pretty safe to use or consume, and that financial products from banks are checked so that they don't just steal my money and lie about the risks. You and me might be smart enough to understand some financial products and the risks, but many other people aren't, so I'm in favor of some laws that cover the bare essentials of safety and honesty (too bad they fail too often, but that's another story). I'm fine though with special banks for people who consciously want to take a lot of extra risks with an absolute minimum of governmental control, but these should be exceptions, not the standard.

It is a completely false assumption that government control increases safety in all these arenas. If we had a free economy, and if some companies and their consumers wanted to subject themselves to a government-controlled regime, I'd not have too much of a problem with that (I'd want them to use their own funds, not my taxes).

I object to bureaucrats imposing their false notions of rationality upon me. I oppose voters like you, imposing your false views of rationality upon me in areas where it is no skin off your nose.

Link to comment
Share on other sites

Adam? Eve? God? I assume you meant that' as empty polemic which should be ignored. If you were trying to make a real point, clarify.
It wasn't smart of me to use the words Adam, Eve, God, because some might get the impression I believe in them while I don't, but the point I was trying to say that I don't think only the voters are responsible, because those are the ones that put the politicians in power. A more extreme example would be to say the parents of the voters are responsible, because they influenced the voters opinion, etc etc, all the way down the line to whatever you think that started this world. I do think both voters and politicians are responsible. Voters because they put politicians in power, politicians because they have power and are expected to understand the issues they have influence on.
Politicians in western democracies are pretty much representative of their voters... they act as agents.
From 'agents' I would expect to ask their voters: "What do you want me to do, and I'll try to do it." In that case I would also hold the voters fully responsible. But I see politicians more as people with strong opinions based on knowledge and experience that they cannot fully explain to their voters, but nevertheless try to convince their voters that it's a good idea. The more they succeed, the more votes they get. But I think they don't loose responsibly on the effects of the execution of their ideas (see WW2).
This is simply false. Depositors lend their money to banks and so they lose; but, lenders lose in every bankruptcy. If GM had gone bankrupt, a lot of people would have been hurt in all sorts of ways.
True, but the fact the banks have FDIC, and other companies don't, makes banks special. You say: then get rid of the FDIC, but I see a difference between lenders to GM and lenders to banks. Lenders to GM choose to take a risk, it's something they see as an investment, but people that deposit money on the bank usually just want their bank to hold on to their money so they don't have to keep everything at home under their pillow. They usually don't want to take any risks, and politicians thought they should have this possibility. That's why banks got an FDIC and other companies didn't. But like I said I do agree the FDIC's 100% reimbursement is a step too far, because it takes too much accountability out of the hands of the banks and their clients.
It is a completely false assumption that government control increases safety in all these arenas.
I'm in favor of minimal control, but not no control at all. For example, I think the government should oblige companies not to lie to their customers or steal from them, and keep checking if they comply with this, but not much more then this (oh, and possibly my 'solution', depending on the arguments against it, which I designed to minimize the risks for tax payers while maximizing the freedom for banks). Edited by solution checker
Link to comment
Share on other sites

... ... the fact the banks have FDIC, and other companies don't, makes banks special.
Yes, I agree. And, it is not just the FDIC. Pre-dating the FDIC is the Federal Reserve -- the "lender of last resort". Government controls breed government controls. One control creates "power" for someone, so the government creates another control to "balance" out that power. Your idea of a negative bonus "clawback" would be one such "check and balance". The current crisis could easily have been avoided if the government had more rules like that. A simple rule saying that nobody can take a mortgage that is more than 80% of the value of their home, and that requires them to pay over 40% of their annual income in mortgage+insurance+property tax, would have ensured the crisis never happened.

It is not at all difficult to reduce risk. If you ask "what rules can the government put in place to reduce credit risk to a bare minimum", the answers are easy to come up with, and they're pretty bullet proof. Taken to the extreme, North Korea does not have banking crises.

The problem is not coming up with risk-aversion rules. The problem is forcing them upon unwilling actors. If I wish to give someone a loan that is 100% of the value of his home, he and I should be free to make such a deal. If he cannot pay, I lose. It is nobody else's concern.

... ... the fact the banks have FDIC, and other companies don't, makes banks special. You say: then get rid of the FDIC, but I see a difference between lenders to GM and lenders to banks. Lenders to GM choose to take a risk, it's something they see as an investment, but people that deposit money on the bank usually just want their bank to hold on to their money so they don't have to keep everything at home under their pillow. They usually don't want to take any risks, and politicians thought they should have this possibility.
It costs money to build bank branches, to buy safe vaults, to run an ATM network, to run web-sites and so on. Some customers might wish for a system where they put their money in a bank and use that bank primarily as a custodian. If so, they should not expect to earn any type of interest. Rather, they should expect to pay some amount for the bank's services. Most customers want a yield on their deposits. They do not simply want a custodial service.

Before the Federal reserve and the FDIC got involved, there were banks that offered this type of custodial service. They were uber-secure, and in times of crises that hit less secure banks, they often helped stabilize the system. The panic of 1907 is the last example of this. Though the U.S. government played a role, the solid New York city banks -- led by J.P.Morgan -- were primarily responsible for stabilizing the system. The only reason they could do so is because they had bullet-proof balance sheets. After 1907, many people in the government were critical of bankers like Morgan, some other bankers wanted a more government-controlled system.

When someone like J.P.Morgan helps a bank, it is almost certain that the bank being helped is solvent but not liquid. The bank could pay out its depositors, if it were given a few years to wind down its positions, but it cannot pay them today. This results in a "run" on the bank. Over decades, a lot of private mechanisms had evolved to prevent runs. Even when there was a run, it was pretty common that the bank was solvent. It was quite routine for banks to have capital of 15% - 20% of their assets, which was more than enough to keep them solvent, even though they were not liquid. The solution is that a banker like J.P.Morgan comes in, takes over the bank, and wipes out the shareholders. If the bank had 80 million in deposits and 100 million in loans and investments, it's shareholder's capital was 20 million. Typically, a run would happen if news broke about the bank's loans going bad. Perhaps the bank had lent money to some railroad that had just declared bankruptcy. Perhaps the banks assets were now only worth 90 million. They were still solvent, but depositors might decide to withdraw their money, and the bank was not liquid.

Though the bank still had capital of 10 million, someone like Morgan would come in and buy the bank for (say) 2 million. Sometimes he might offer to buy it for less than zero! Most banks do not get all their funds from regular depositors. They also borrow via long-term bonds. A bank may have 100 million in loan and investments, backed by 70 million in deposits, 15 million in long-term loans via bonds, and 15 million in capital. Someone like Morgan may tell the creditors of the bank that he will save it if they agree to take a haircut, where he would give them only 10 million instead of the 15 million they were owed. The result of such a system is that lenders and depositors keep learning. All sorts of rules and contract conditions evolve: like the hierarchy of "senior creditors"/"junior creditors" etc.

The bankers who took on too much risk, don't see it that way. Their thinking goes like this: "If Morgan would give me his money for a year, I could easily wind up my loans. I would take some loss, but not as much as I do when I have to make a deal with Morgan." A few of these bankers, along with some statist politicians, came up with the idea that the government should step in and buy their assets in situations like this. The result was the Federal Reserve. Did the Federal Reserve ensure that banks kept higher capital-reserve ratios than they did before? No; just the opposite. The Federal Reserve kept lowering capital-reserve requirements. Since there is tax-payer money standing behind a bank, it could now get down to much smaller ratios and a still be covered by the Feds. Obviously, the Fed had to come up with rules about how a bank's assets and investments should be valued and how risk would be computed. The Federal Reserve is one of the major reasons banks started to take on more risk, and it is a major reason banks like Morgan's could no longer survive using their old, safe methods. They had to compete. The FDIC then made this even more so.

Over decades, we have built rule, upon rule, upon rule and booms and busts have not gone away. The net result of the system is as follows: previously impacts were felt mostly by those who took on bad risks (intentionally or by mistake). Today, the risk and loss is "socialized" out to the entire tax-paying population. So, I end up paying for Freddie and Fannie's mess. The solution is to stop thinking in a way that puts the aggregates as primary. The economy is composed of millions of actors. What we have now is a system where those who act safely are penalized more than they would under a private system.

Our current crisis was not merely the result of some bankers taking on more risk than they ought to. Their government-sponsorship was essential. They would never have been able to do what they did without government backing. The vast majority of bankers understand risk and who are careful about it. Even though the government has lowered the standards drastically, most banks stood up well in the current financial crisis. Washington Mutual, Countrywide, Merrill Lynch, Bear Stearns and Wachovia were all large, but they were all absorbed by other large banks with stunningly little disruption to anybody. Lehman was allowed to go into bankruptcy, and the world did not end. It is quite possible that AIG could have been similarly wound up. The three biggest institutions behind the mess were Citibank, Freddie Mac and Fannie Mae. These were the ones that needed the huge bailouts.

The solution is not to have a system where a Citibank can exist. Robert Rubin and Alan Greenspan encouraged banks like Citibank, and that is the main reason why Citi could take on so much risk. Then, Robert Rubin joined Citi while his protege, Tim Geitner, looked out for him in the new Obama government. This type of nexus between shady businessmen and corrupt government officials is exactly what one gets when the government pokes its nose into the system. It becomes a matter of who you know. Money is clean and honest. When you put government into the mix as a huge player -- not just as a policeman -- corruption results.

The same process can be seen in the other big recipients of bailouts: Fannie and Freddie. These were government-created institutions that should not exist. They have distorted the mortgage marketplace by their existence. They used a government guarantee to underwrite mortgages. For a large part of their history, they played it safe, and the net result was that every mortgage borrower was getting a slight benefit at the cost of other tax-payers. Not catastrophic. Then, someone decided to allow Fannie to be "more private" by splitting it in two, and by creating Freddie. On paper, the government said it no longer guaranteed Freddie and Fannie, but their status was always ambiguous: they were still "government sponsored". People who understood history, understood that the government would actually stand behind Fannie and Freddie if push came to shove. Knowing this, they were willing to lend to Fannie/Freddie at low rates. During the housing boom, Fannie/Freddie started to buy sub-prime mortgages. In essence, the government was implicitly subsidizing the boom of sub-prime mortgages.

Even worse, the government had come up with rules that said that financial institutions must try to serve "under-served" populations and provide wider access to credit. Institutions were rated, getting "credits" for various schemes. There was no direct and clear payoff from the government, but that's just the way these things work. When you don't have clean profit-and-loss, it becomes a subtle games of "you scratch my back and I will scratch yours". For example, many credit card companies set up special departments to try to give credit cards to poorer people, and to racial groups like Blacks and Hispanics, not because they wanted to milk the poor, but because they wanted to get their credits with their regulators. Fannie and Freddie were given credits for their purchases of sub-prime mortgages. The government -- as always -- was not encouraging safety, but encouraging easy credit. Hey! it's tax-payer money.

The point of this long history is this: you can come up with one more little rule, but it will be of no avail. To fix the system, you have to take the government out of it.

Link to comment
Share on other sites

A few of these bankers, along with some statist politicians, came up with the idea that the government should step in and buy their assets in situations like this. The result was the Federal Reserve.

Hi sNerd, thanks for your extensive reply. I have only one question. You make it sound like the FED is another example for government interference with the market that worked out pretty terribly. The way I see it, it's just the opposite, considering that the FED is not a government organization but a private bank, invented and initiated by private bankers. These bankers told the government: "You don't get the economy, so leave it to us, the market.": similar to your message. The government agreed to 'free the economy' by giving away a lot of power to the FED, and the consequences aren't too pretty, as you have pointed out. So if it were up to me, I'd give those powers back to the government.

I did come up with a new, probably better solution that I'd like your opinion on. I call it Virtual Banks. It works like this:

1. Take the government out of the banks (I'm sure you like this part ;) ).

2. When a bank goes bankrupt, it's clients loose their money (no more FDIC), so they can't pay for living, food, schooling etc. so their lives would be extremely disrupted. Here's where the virtual banks come in.

3. A virtual bank is an online service that you pay a small monthly fee for. You get an account, and you can put money on it or take money from it. However, this virtual bank doesn't keep your money, but distributes it over several banks of your own choice. Let's say you as a client choose 10 banks, and set them all at a 10% share. When one bank goes bankrupt, you loose 10% of your money, but you can still pay for your housing/food/schooling/etc.

This way you have the best of both worlds, don't you agree?

Edited by solution checker
Link to comment
Share on other sites

... However, this virtual bank doesn't keep your money, but distributes it over several banks of your own choice.
Sure. It is one of the things that might evolve if there's a free market in banking. People already do a version of this today. The FDIC guarantees up to $250,000 for each customer. So, a rich person who wants to place more than that in CDs or other bank accounts, will often place the money in multiple banks, staying below the FDIC limit in each bank. They sometimes do this via agents who act a bit like the virtual bank you propose.

Theoretically, if a bank that is well diversified, you will not get more portfolio-diversification by putting the money in another bank. A good bank will always diversify its risks. For instance, it might limit the total amount of loans that it will put into homes, into commercial buildings, into industries, etc. It might also diversify geographically, so that its loans are spread out across the country, and even around the world. It will diversify the durations for which it lends money: some short term, some long-term.

Still, there's is always the risk of a bad actor or some other single-point-of-failure. So, it makes sense for a depositor to diversify. Just like we have "mutual funds" for shares, one could have something like you suggest across banks.

You make it sound like the FED is another example for government interference with the market that worked out pretty terribly. The way I see it, it's just the opposite, considering that the FED is not a government organization but a private bank, invented and initiated by private bankers.
Even at its inception, the Fed was never a truly private organization. This was not a group of bankers that got together and could be ignored by all the other bankers. It was a typical industry group trying to use the power of government to prop up the industry as a whole. In practice, that means propping up the poorer players in that industry at the expense of the weak. After 1907, it was not Morgan who was clamoring for a Fed. It was some of his lesser rivals. The Fed was not organized for private bankers. It was organized against good private bankers.

Nor has the Fed maintained some independence of other industry-groups. Over time, it has evolved into being an organ of government. It does not matter what the technical ownership rules are: who owns shares of the Fed. The key is: who calls the shots. For many decades there has been absolutely no doubt that the Fed is controlled by the government in the same way as any other organ of government.

Added:

Just wanted to say that I appreciate this discussion, and the way you try to come up with solutions. It is clear that you're actively engaged and open-minded. So, even though we don't agree on issues, thanks for that.

Edited by softwareNerd
Link to comment
Share on other sites

Hi sNerd, thanks, I also enjoy it. It's good to rub and polish your brain against that of others (Michel de Montaigne). That said, we apparently have a very different view on what the FED is.

For many decades there has been absolutely no doubt that the Fed is controlled by the government in the same way as any other organ of government.

That is not my impression at all. You cannot be in debt of yourself, even if you would like it. That's true for you, but also for a government. The government owes more money to the FED (1.6 trillion and counting) than it does to China, so the FED is not the government. Rep. Ron Paul tried to cancel this debt, but failed. Also, the supreme court ruled the FED is a private institution. The big difference between governmental institutions and private institutions is that governmental institutions (should) have the intention to do what's best for the people, and private institutions do what's best for themselves. For the FED it was in their best interest to built up a huge smokescreen, trying to give people and politicians the impression they're federal (It's in the name, so it must be federal right? Or maybe not??? ;) , like allowing the government to appoint the board of directors, transferring a lot of their profit to the Treasury, being a central bank and so on. But as soon a those government appointed managers are at work, their job is to do what's best for the FED, not what's best for the people.

Another funny thing is that China had to work to earn the money they loaned to the US. So where did the FED come up with 1,6 trillion to loan out against interest to the government? Did they also sell billions of microwaves? Nope, just go a nice contract signed 2 days before Christmas 1913, while many members of Congress were home for Christmas, that gave them authority to make up as much money as they liked, without paying any taxes or control by e.g. IRS etc. And the governmental control is a joke, as can be witnessed https://www.youtube.com/watch?v=OhZFYGFbTPA. Anyway, I could continue, but probably you heard this story often enough and know just what's not true about it, so I'm curious what is untrue about what is said

(and, if you feel like it,
). Thanks! B. Edited by solution checker
Link to comment
Share on other sites

... ... we apparently have a very different view on what the FED is.
The nature of the Fed has been discussed before. I really don't want to go into it again. Perhaps someone else will respond. Otherwise, try search.

My advice is this: if anyone tells you that the Fed is private, ignore everything they ever say to you on banking, economics and the Fed.

Link to comment
Share on other sites

Guess wrong as opposed to what? Guess right? There's no guessing right. If you're guessing, you're wrong.

That seems like the perfect outlook on life to kill all innovation, change and progress.

The nature of the Fed has been discussed before. I really don't want to go into it again. Perhaps someone else will respond. Otherwise, try search.

My advice is this: if anyone tells you that the Fed is private, ignore everything they ever say to you on banking, economics and the Fed.

That's too bad. This is what the Dutch page of Wikipedia says about the FED (translated). I hope someone on this forum is willing to make corrections, because if nobody does, I'll continue to believe that it's all true:

The Federal Reserve System or the Federal Reserve (also known informally as The Fed) is the private, central bank of the United States of America, similar to the European Central Bank in Frankfurt. The Bank is governed by a Board which is appointed by the President. Although the Federal Reserve name suggests otherwise, the bank is not owned by the state: the shares are required by all participating banks ("members"). All banks with a federal banking license should be member / shareholder, banks with a license from a state may choose to do so if they meet certain conditions. The Bank is principally engaged in monetary policy. In addition, the bank is monitoring domestic payments. The current Fed Chairman is Ben Bernanke. He was appointed by President George W. Bush. His predecessor was Alan Greenspan.

Although I'm Dutch, I prefer discussing US economics, because the Dutch are too boring (Our central bank is simply owned by the government, so we don't have interesting books like this (most helpful customer review: "It should be remembered that the Fed is a privately owned bank!!"))

Edited by solution checker
Link to comment
Share on other sites

That's too bad.
I tried searching for old threads, but could not find on -- though I'm pretty sure it exists. Anyhow, my answer is really in my post above. A gangster can make people pay him protection money and call it "shares in Mafia Inc.". The real question is about control. The Fed is a good example of fascist system, because it retains some nominal private features, but is fully controlled by the government. When it comes to control, day-to-day bureaucratic membership and power over others -- the real distinguishing features -- the Fed is indistinguishable from a government regulatory agency.

That Wiki article was probably written by some Libertarian fruitcake. (Don't get me started on Ron Paul!)

Link to comment
Share on other sites

Join the conversation

You can post now and register later. If you have an account, sign in now to post with your account.

Guest
Reply to this topic...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoji are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...
 Share

  • Recently Browsing   0 members

    • No registered users viewing this page.
×
×
  • Create New...