… … 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.
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