The Safe Banking Fantasy

by Gary North

Recently by Gary North: College for Dummies... and Non-Dummies

Occasionally, we see an official attempt at a serious discussion of what Federal Reserve System economists would like the public to believe is safe banking. This means safe fractional reserve banking. This means fraudulent safe banking. This means fantasy banking.

All fractional reserve banking rests on a legal promise: you can get your money out at any time. Yet the money that you deposit is loaned out by the bank. This means that your money is gone. Then how can you withdraw it at any time? Only if (1) the money is loaned out on a "repay instantly on demand" basis, or (2) hardly anyone will demand withdrawal at the same time. The bank will pay you out of its tiny slush fund for withdrawals. The first option assumes that the debtor is always in a position to repay at any time, which is of course ludicrous for most corporate and business borrowers. They will not agree to such terms. The second option is equally ludicrous during a banking crisis.

In other words, all fractional reserve banking is based on a legal deception of the depositors. A depositor cannot get his money back when a lot of other depositors want to get their money back. This is called a bank run. All fractional reserve banking systems eventually experience bank runs.

During bank runs, bankers call on the government to bail them out. The government and the central bank bail out only the biggest banks. They let the smaller banks go under. Then big banks buy the assets of the smaller, now-busted banks at discount prices. The government (FDIC) pays off depositors with $250,000 or less on deposit. Taxpayers therefore subsidize the buying spree of the biggest banks. This is justified as "saving the banking system." The politicians provide taxpayer money every time.

I remember an on-camera testimony of Congressman Brad Miller, a Democrat Congressman from North Carolina, just before the TARP bailout. He said that his constituents were evenly divided between "no" and "hell no." He of course voted for the bailout, as did most of his colleagues. He was of course re-elected.

The voters did not really care. They screamed about the bailouts, but they refused to impose negative sanctions on all of the Congressmen who voted for TARP. Until there is real pain, they usually re-elect their Congressmen. They perceive, correctly, that their opinions do not count when big banks are asking for handouts in a crisis. The voters want their lifelong bailouts, and as long as their Congressmen bring home the pork, they really don't care. By "care," I mean an automatic vote for the challenger at the next election. Congressmen generally understand only one thing: defeat at the next election. Ron Paul doesn't care, and maybe Dennis Kucinich doesn't care, but most of them care deeply.

So, the #1 goal of most politicians, all bureaucrats, and all central bankers is to make sure that the voters feel no pain – at least not pain bad enough that might lead to (1) a new Congress, (2) budget cuts for bureaucracies, and (3) the nationalization of the central bank.

A SCARED CENTRAL BANKER

On June 3, Daniel Tarullo, a member of the Board of Governors of the Federal Reserve System, which is a government-owned institution, unlike the regional Federal Reserve banks, gave a speech at the Peter G. Peterson Institute for International Economics. Peterson until 2007 was the Chairman of the Council on Foreign Relations. As such, he was among the most influential men on earth. He served as Secretary of Commerce (1972-73). He was the CEO of Lehman Brothers (1973-84). He co-founded the Blackstone Group. He is concerned about the growing Federal debt, on-budget and off-budget, which he correctly perceives as a threat to the world's capital markets.

Tarullo's topic was the systemic risk of the world's interconnected banking system. This is surely a relevant topic. When I think of the international banking system, I think of Tom Lehrer's nuclear war song a generation ago: "We will all go together when we go. Every Tom, Dick, Harry, and Every Joe."

He focused on the Dodd-Frank law's requirement that the Federal Reserve System establish prudential standards for "systemically important financial institutions or, as they are now generally known, 'SIFIs.' My focus will be on the requirement for more stringent capital standards, which has generated particular interest."

Keep this acronym in mind: SIFIs. It means very large banks, meaning very large, highly leveraged, highly profitable corporations whose collapse would create a chain reaction in the financial markets. In the old days, SIFIs were called TBTF: too big to fail.

Tarullo made a significant admission: "It was, after all, a systemic financial crisis that we experienced and that led to the Great Recession that affects us still today." That's the official party line. It was used to justify TARP and the other 2008 bailouts, such as swaps at face value of liquid AAA-rated Treasury debt held by the FED for toxic assets held by the SIFIs. For a skeptical analysis of the party line, read David Stockman's response.

Tarullo admitted that the old system of regulation failed to deal with systemic risk. Or, to put it differently, the horse got out of the barn, and now the Dodd-Frank law has increased the responsibility of the FED to regulate things better. But the FED regulated the system before. This is the standard government response: reward failure with greater responsibility.

The pre-crisis regulatory regime had focused mostly on firm-specific or, in contemporary jargon, "microprudential" risks. Even on its own terms, that regime was not up to the task of assuring safe and sound financial firms. But it did not even attempt to address the broader systemic risks associated with the integration of capital markets and traditional bank lending, including the emergence of very large, complex financial firms that straddled these two domains, while operating against the backdrop of a rapidly growing shadow banking system.

But things will be different Real Soon Now. The FED is going to regulate large banks on a comprehensive (macroeconomic) basis. This assumes that a committee of salaried bureaucrats who do not own the banks or have any assets of their own at risk will be able to design fail-safe rules that will coordinate the decisions of depositors and bankers inside the United States. Of course, the system is international, so the USA is dependent on decisions made by bureaucrats, bankers, and depositors around the world. But Dodd-Frank did not cover them.

A post-crisis regulatory regime must include a significant "macroprudential" component, one that addresses two distinct, but associated, tendencies in modern financial markets: First, the high degree of risk correlation among large numbers of actors in quick-moving markets, particularly where substantial amounts of leverage or maturity transformation are involved. Second, the emergence of financial institutions of sufficient combined size, interconnectedness, and leverage that their failures could threaten the entire system.

In short, the FED's economists, who failed to foresee what would happen to a few banks in 2008, are now going to foresee what will happen to lots of banks, including multinational banks that are interconnected with SIFIs all over the world.

He assured his listeners that "No one wants another TARP program." No one wants hyperinflation, Great Depression II, or both. The question is: What can a bunch of regulators do to prevent this? "In order to avoid the need for a new TARP at some future moment of financial stress, the regulatory system must address now the risk of disorderly failure of SIFIs."

There is a theoretical problem here. Risk can be estimated by use of statistical analysis. An example is life insurance tables. Uncertainty cannot be estimated, such as life insurance tables during a nuclear war. These are called "acts of God," and insurance companies write contracts to escape liability.

A systemic failure is triggered by an event that is not governed by the law of large numbers, i.e., risk analysis. It is triggered by an event that is inherently uncertain. That was why Long Term Capital Management went belly-up in 1998, despite its sophisticated formulas based on the work of two Nobel Prize-winning economists.

He referred to an international agreement known as Basel III. That is the successor to Basel II, which was not enforced and which achieved no protection from 2008. "The Basel III requirements for better quality of capital, improved risk weightings, higher minimum capital ratios, and a capital conservation buffer comprise a key component of the post-crisis reform agenda." It all sounds so reassuring. But what authority does the committee have to impose sanctions? None. "Although a few features of Basel III reflect macroprudential concerns, in the main it was a microprudential exercise." In short, it ignored The Big Picture.

We need to pay attention to The Big Picture. "We" means Federal Reserve economists who have formulas, but who were not smart enough to win a Nobel Prize.

Here is the problem:

There would be very large negative externalities associated with the disorderly failure of any SIFI, distinct from the costs incurred by the firm and its stakeholders. The failure of a SIFI, especially in a period of stress, significantly increases the chances that other financial firms will fail. . . .

He argued that the SIFIs must increase their capital reserves. Increased capital means lower leverage. It means a reduced ROI: return on investment. So, a SIFI will not do this without regulation. "A SIFI has no incentive to carry enough capital to reduce the chances of such systemic losses. The microprudential approach of Basel III does not force them to do so." Quite true. So, what is the FED going to do about it? And how, exactly, can the FED get foreign SIFIs to do it?

What has been done so far? Committees have been set up. This is basic to the theology of all modern civil government: salvation by committee. "Together with the FDIC, the Federal Reserve will be reviewing the resolution plans required of larger institutions by Dodd-Frank and, where necessary, seeking changes to facilitate the orderly resolution of those firms."

Still, we must acknowledge that we are some distance from achieving this goal. The legal and practical complexities implicated by the insolvency of a SIFI with substantial assets in many countries will make its orderly resolution a daunting task, at least for the foreseeable future. Similarly, were several SIFIs to come under severe stress, as in the fall of 2008, even the best-prepared team of officials would be hard-pressed to manage multiple resolutions simultaneously.

I see. "Some distance." "Practical complexities." "Daunting task." In short, they don't know what they are doing. The formulas are not yet clear. The appropriate sanctions are not yet on the books. So, it's "pray and patch." It's bureaucracy as usual.

"I HAVE A PLAN"

He offered a five-step program. Point one is choice:

. . . an additional capital requirement should be calculated using a metric based upon the impact of a firm's failure on the financial system as a whole. Size is only one factor to be considered. Of greater importance are measures more directly related to the interconnectedness of the firm with the rest of the financial system. Several academic papers try to develop this concept based on inferences about interconnectedness from market price data, using quite elaborate statistical models.

Oh, boy. Academic papers! Yes, my friends, academic papers, written by Ph.D.-holding economists who have never run a bank or anything else. That will do the trick!

Others have proposed using more readily observed factors such as intra-financial firm assets and liabilities, cross-border activity, and the use of various complex financial instruments.

So, the experts do not agree. Surprise, surprise! Then whose system will win out? None. A committee will decide how to coordinate all these proposed solutions.

Second, the metric should be transparent and replicable. In establishing the metric, there will be a trade-off between simplicity and nuance. For example, using a greater number of factors could capture more elements of systemic linkages, but any formula combining many factors using a fixed weighting scheme might create unintended incentive effects.

You know: transparency. It's the new mantra. It's a revision of Woodrow Wilson's "open covenants openly arrived at." Trust them!

"Systemic linkages." "Formula combining many factors." "Fixed weighing scheme." Yes! Yes! I believe!

On the other hand, using a small number of factors that measure financial linkages more broadly might reduce opportunities for unintended incentive effects, but at the cost of some sensitivity to systemic attributes of firms. Whatever the set of factors ultimately chosen, the metric must be clear to financial firms, markets, and the public.

Clear. It's all so clear. Doesn't it appear clear to you? It does to me.

This is transparency, all right: the transparency of the wardrobe worn by the emperor, who had the best tailors money could buy.

Tarullo went on and on. The fifth point was the corker: international cooperation with independent agencies, all according to Basel III standards, which will be imposed by 2019. They promise!

Fifth, U.S. requirements for enhanced capital standards should, to the extent possible, be congruent with international standards. The severe distress or failure of a foreign banking institution of broad scope and global reach could have effects on the U.S. financial system comparable to those caused by failure of a similar domestic firm. The complexities of cross-border resolution of such firms, to which I alluded earlier, apply equally to foreign-based institutions. For these reasons, we have advocated in the Basel Committee for enhanced capital standards for globally important SIFIs.

Achieving and implementing such standards would promote international financial stability while avoiding significant competitive disadvantage for any country's firms. I would note in this regard that it will be essential that any global SIFI capital standards, as well as Basel III, be rigorously enforced in all Basel Committee countries.

I have summarized half of his speech. The rest of it is equally concrete, realistic, and inspirational. You can read it here.

CONCLUSION

This is the best the FED has to offer. This is one Board member's proposed solution to systemic risk, which is in fact systemic uncertainty. It is a salaried bureaucrat's proposed solution to the inherent uncertainties imposed by fractional reserve banking – a system whose major players are politically protected from failure, and which therefore subsidizes high leverage and high returns . . . until the day the dominoes begin to fall.

We are asked to believe that Federal Reserve economists can design a coherent, enforceable system of controls to protect the world from leveraged banks that overestimate the ability of their formulas to protect them from uncertainty. We are asked to believe that salaried economists at the FED and all other major central banks can produce a better formula, and then impose it in ways that profit-seeking bankers cannot evade.

My conclusion: we will all go together, when we go.

June 8, 2011

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2011 Gary North

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