"Three major factors have been identified as changing the nature of bank risk: (1) the decline in bank asset quality and in capital ratios; (2) the greater reliance on purchased funds (liability management) in an environment of rising and increasingly volatile interest rates; and (3) the continued expansion into nonbanking and off-balance sheet activities."
Point 1 and Point 2 may refer to banks investing in toxic mortgage-backed securities and real estate that later imploded. Securities jam-packed with subprime mortgages and falsely rated as AAA and the housing bubble created huge returns for investors. Banks spent their capital to chase these high returns. Unfortunately these were assets of the ticking time bomb type: when the market revealed their poor quality, the invested capital evaporated overnight.
Part 3 may be where those Wall Street banks are directly responsible. When the repeal of the Glass-Steagall Act allowed investment firms and banking institutions to merge, they went on a feeding frenzy. Part of the frenzy involved some creative accounting that let them keep their true exposure off the books. For years everyone thought the banks were incredibly profitable and well-capitalized, when in actuality they were tens of billions of dollars in the hole.
The author notes that the Federal Reserve is a failing bank's lender of last resort, and holds in its hands the power to save the banking industry. When the Fed provides an emergency loan to a viable bank, that bank can pull itself back from the brink:
"[B]ank failures can only occur if the Federal Reserve neglects to provide - either through the discount window or through open market operations - the additional reserves needed to support the sound banks of the system." Too bad that, "typically the Fed has not extended discount window privileges to all institutions (i.e., failing and sound)."
But wait! you may say. What about the FDIC? Can't they come to the rescue? Well...
"[T]he deposit insurance program cannot make 'discretionary' errors of the type attributed to the Fed during the panic periods of the 1930s.... However, it is also clear that the FDIC's insurance fund (including its currently authorized borrowing lines with the Treasury and other government agencies) is too small to cover major disturbances to the banking system such as the effect of a succession of outright defaults."
Here we have just one of many studies that identifies the cause of the crisis and provides a road map to prevent another one. The only problem?
This study was published in 1986*.
Since then, history repeated itself in the 1990s and again in 2007, despite legislation and regulatory reform enacted after each crisis. And despite numerous studies. In fact, the problem has grown worse as the banking industry is controlled by a few large (too-big-to-fail) banks:
"[I]f a bank gets big enough to be considered too big to fail, it gets implicit guarantees for all its liabilities, whether they are insured deposits or not. The bank does not have to pay for these guarantees, since deposit insurance premiums are only assessed against deposits. So, in essence, attaining a certain size provides a bank with some free insurance and more complete coverage than it would get otherwise."
So warned an author in 1994**. How quickly we forget, as Glass-Steagall was repealed in 1999, leading to way-too-big-to-fail Wall Street behemoths. And the FDIC fund, which couldn't even cover a banking crisis in the 1980s, gets wiped out to the point that it has to borrow from the banks it bailed out.
And that, my friends, is why regulation will never prevent an economic meltdown.
* Merrick, J. J., Jr., & Saunders, A. (1986). Bank regulation and monetary policy. Journal of Money, Credit and Banking, 17, 691-717.
** Boyd, J. H., & Graham, S. L. (1994). Investigating the banking consolidation trend. Federal Reserve Bank Minneapolis Quarterly Review, 2-21.
No comments:
Post a Comment