Safe Banking Fantasy
by Gary North: College
for Dummies... and Non-Dummies
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.
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
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
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.
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.
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
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.
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."
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.
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.
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
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.
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.
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.
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
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.
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.
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
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
Here is the
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."
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.
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!
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
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
You know: transparency.
It's the new mantra. It's a revision of Woodrow Wilson's "open covenants
openly arrived at." Trust them!
"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.
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.
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!
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.
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.
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
we will all go together, when we go.
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.
2011 Gary North
Best of Gary North