Opinion

Edward Hadas

Fear, greed and bank capital

By Edward Hadas
July 17, 2013

Buildings should be strong enough to withstand storms and earthquakes. Similarly, banks should be able to remain upright after massive waves of losses. Engineers have a pretty good idea of how to make skyscrapers strong. The regulators and lawmakers who set the rules for big banks are still struggling, five years after the government rescue of many American and European banks.

Bankers and their defenders say that the struggle is over. The financial structures have been reinforced: deeper capital foundations, new supports added and weak materials removed. But many critics point out that the banks have not done the one thing necessary – to double or triple the ratio of shareholders’ equity to total assets. That is the only sure way, they say, to guarantee that large losses on loans do not threaten the ability of the institution to remain standing.

I think the critics are largely right. As economists Anat Admati and Martin Hellwig explain in their book, The Bankers’ New Clothes, the bankers’ almost instinctive aversion to equity protects bonuses and shareholders at the expense of the general public. Still, in my view banks have a more fundamental problem than poor capital structures. It is society’s unreasonable expectations of what they can accomplish.

The best way to make banks disaster-proof is to eliminate an irrational fear which makes banks too big and to resist the dangerous greed which makes them too brittle.

It is quite rational to fear a sudden banking system collapse, but economists and politicians are much too worried about a sharp decline in lending. While such a credit drought is always a possibility, right now the greater danger is from a continuing credit flood.

Regulators and economists pay attention to the supposedly meagre flow of credit to small businesses. That may be a problem – the evidence is mixed – but it pales before the excesses.

There is too much lending from one financial institution to another and too much public-sector borrowing for the sake of unjustifiable lower taxes or higher spending. Governments borrow wildly, while mortgages and consumer loans leave more families in precarious financial positions. National levels of leverage remain at record highs, even before considering the debt hidden in derivatives.

As for greed, it is easy to pick on bankers, but they have become a scapegoat. Everyone who puts money into banks is guilty. Shareholders want too high dividends, buyers of bank debt refuse to accept losses and depositors demand absolute safety. All of them want more than is reasonable. Banks should not squeeze vast profit out of the economy, and they cannot fully escape the real economy’s ups and downs.

What would banks look like without the misdirected fear and the nearly ubiquitous greed? They would certainly have more equity, but I think society would demand something more: a different banking system. I would suggest a three-part arrangement.

Start with purely transactional Narrow Banks. They take no risk, holding their funds in the electronic equivalent of mattresses. The need for such institutions is obvious, once the exaggerated fear of insufficient credit is removed. The money used for payrolls and bills should be safe and totally separate from the funds dedicated to the inherently risky business of saving, lending and investing.

Second come anti-greed institutions, Safer Banks. Unlike Narrow Banks, they make loans, but only relatively safe ones. They are tightly regulated, charge modest interest rates and promise depositors moderate returns. These promises can almost always be kept, but when they cannot, when literal or figurative tsunamis hit, the depositors will suffer. That risk should be made clear, perhaps by designating a small portion of the deposits as “risk shares” which offer variable returns.

Finally, there are Riskier Banks, which put money in riskier enterprises, offering more potential gains for depositors and investors who are willing to bear more potential losses. Today’s banks are mostly Riskier, but their business model – high default rates on loans, high interest rates for borrowers and high promised returns to some providers of funds – makes them liable to disastrous sudden collapse.

Regulators are improving their rescue techniques. However, it makes more sense to address the structural flaw. Riskier Banks should take much less risk on their own account. They should simply pass through a variable stream of payments from borrowers to depositors.

To keep the stream from excesses, loans with high interest rates should be replaced with more flexible products. Defaults would be rarer if payments varied along with some measure of economic activity: income, inflation rates or a collection of general economic indices.

The design of such flexible products is a job for financial engineers. Up to now, the profession has largely wasted its skills in modelling and analysis. Their products often encouraged reckless behaviour. The engineers could redeem themselves by designing sounder banks.

Comments
12 comments so far | RSS Comments RSS

Wow, I usually agree with you on most everything, but some of your statements in this piece scare me. ” inherently risky business of saving,”? Saving should not be inherently risky. It never was before, and still isn’t in most of the world. The US banksters have basically eliminated the possibility of saving by forcing savings into market driven schemes. Of course, I’m speaking as an individual, an average citizen, not an investor or wanna-be-bankster.

Posted by tmc | Report as abusive
 

Good god, Mr. Hadas. How can you possibly think you’re writing a credible op-ed about banking reform without even referencing the Godzilla in the room, our corrupt, quid pro quo government that has more incentive to serve the will of our risky, greedy banking system than the American people? That’s like reading aloud scripture during an orgy. What’s the use?

Your suggestions strike me has having a lot of merit, but what good is that when the banking industry is channeling money into the pockets of our elected officials to make sure they DON’T reform our banking system? If you have any doubts about what I’m saying, let’s sit back and watch what happens to the new Glass-Steagall act currently being proposed by Senators Warren and McCain. I don’t know about you, but I’m pretty confident that I know what’s going to happen to it; the same thing that’s happened to similar bills in the past. And it won’t be based on its merits, or its shortcomings, though that’s always the “go to” excuse used for killing such bills.

I can’t verify this, but I’ve read that the banking industry is already spending big money to kill this bill. If history is any guide, I’d say that’s a pretty safe bet. It’s just too easy to do now. The usual process is for industry lobbyists to tell the Republicans what they want to see happen with a bill. Republicans then march in lockstep to do the industry’s will. Then the lobbyists approach a few key Democrats for safe measure. Gotta secure a majority. Heck, the Republicans are still try to get rid of the Affordable Care Act (as if our healthcare system was fine just the was it was) and the ACA was passed over 3 years ago. I’m not suggesting that the Democrats have clean hands. Not at all. But Democrats have to make SOME effort to serve the people because that “image” is all they’ve got going for them. At least supporters of the Democratic Party don’t just swallow industry propaganda as fact like supporters of the Republican Party seem to do. People may not like hearing that, but if you consider the positions held by voters on issues such as healthcare, energy and guns, it will bear out my assertions.

The bottom line is this. The wealthy and powerful industries dominant in this country have our government in their pockets–both parties. They’ve done a masterful job of fine tuning how their industries interact with our economic system in order to maximize their profits, which is their raison d’etre. Unfortunately, the greatest maximizing of an industry’s profits is rarely, if ever, what is best of our society at large, especially over the long haul. Robust profits are great; maximizing profits at all costs, not so great. Both our banking and healthcare industries are perfect examples of that. You can add our investment industry, our gun industry, our energy industry and our defense industry to that list. It’s also happening to our prison system, as we march toward privatizing our prisons, where owners require a certain percentage of occupancy at all times. What a way to determine the guilt or innocence of their pawns…er, I mean, the people. The greater the cash flow, the more influence an industry tends to have (naturally.)

There’s little we can do to change the banking system until we fix our government. We need to bring an end to special interest payoffs to our government officials. I personally think publicly financing our elections would be the best way to control private sector money going to our elected officials. We also have to end the revolving door that has our legislators passing legislation favorable to companies and industries, and later leave politics to take a lucrative job within the same industries, or their lobbyists, that benefited from the legislation the politician had a hand in formulating and passing.

Unfortunately, when it comes to reforming our government we run into the same steel wall we run into when seeking to reform our banking industry. The same crooked legislators who are benefiting from this system can’t be expected to change it so that they no longer receive the benefits. Something big has to come from the people and we’re a long way off from that.

Posted by flashrooster | Report as abusive
 

Great rant there flashrooster! Covered a lot of topics, but well said.

Posted by tmc | Report as abusive
 

I congratulate you once more on your financial perception, Mr. Hadas.

TMC would seem to have a point until one considers the relentless and deliberate dilution of the purchasing power of the American dollar by it’s very custodians that have turned saving money “for a rainy day” or for one’s old age into Mr. Hadas’ “…inherently risky business… and made the purportedly inflation-protected purchasing power of Social Security benefits a government-controlled “shell game”.

Flashrooster and I have seldom agreed on much, and yet here even he admits that “Your suggestions strike me has having a lot of merit…”. When he accuses you of not “…referencing the Godzilla in the room, our corrupt, quid pro quo government that has more incentive to serve the will of our risky, greedy banking system than the American people…” I think he somehow missed your following words:

“There is too much lending from one financial institution to another and too much public-sector borrowing for the sake of unjustifiable lower taxes or higher spending. Governments borrow wildly, while mortgages and consumer loans leave more families in precarious financial positions. National levels of leverage remain at record highs, even before considering the debt hidden in derivatives.”

Flashrooster is quite correct in pointing out that “The same crooked legislators who are benefiting from this system can’t be expected to change it so that they no longer receive the benefits.” “There’s little we can do to change the banking system until we fix our government. We need to bring an end to special interest payoffs to our government officials.”

I stand squarely with all three of you on this.

Posted by OneOfTheSheep | Report as abusive
 

OneOfTheSheep: I read Mr. Hadas’s piece from the first word through to the last. The writer can speak for himself, but I don’t think he was accounting for the US government’s corruption when he references our government’s inability to control our debt. One side refuses to budge on raising taxes and the other refuses to budge on cutting spending. The result is over leveraging. I suppose one could make a circuitous argument that our spending/taxing problem is a result of government corruption, but the same stalemate dynamic could very well exist if we didn’t have a quid pro quo system of corrupt governing, and I don’t think corruption is what Mr. Hadas had in mind in that passage. Incompetence? Maybe intransigence? An unwillingness or inability to compromise? Perhaps. But not government corruption. If he was referring to government corruption, he’d probably have written government corruption.

I’m pleased, however, that you didn’t lecture me this time for promoting anarchy for stating, “The same crooked legislators who are benefiting from this system can’t be expected to change it so that they no longer receive the benefits. Something big has to come from the people and we’re a long way off from that.” You used to be less inclined to approve of any kind of serious demand making on the part of the American people. That’s good. If enough of us come together and, if necessary, take to the streets, maybe we’ll get the change we need. Real change this time. It’s important that we all accept the fact that there will be extremely heavy resistance to ending our government’s corruption, and I don’t think the worst of it will come from the government. He who holds the wealth is he who holds the power.

Posted by flashrooster | Report as abusive
 

Well said. Riskier banks should be allowed to be called banks. The word bank carries with it the implied guarantee that it is very, very safe.

Posted by BidnisMan | Report as abusive
 

Whoops. I meant shouldn’t. Copy that: should NOT be allowed to be called banks.

Posted by BidnisMan | Report as abusive
 

Interesting proposal. One thing comes to mind, though.

How does one determine what is risky, especially considering that the nature of risk changes though time.

For example, bonds are generally considered to be a safe investment, but now with interest rates near zero and no where to go but up, the bond market is less safe.

Furthermore, how safe are government bonds, really? There are a great many states, counties and cities who are dancing near the edge of insolvency. The Federal government would be in even worse shape except that it is able to print money… makes holding government debt a money losing proposition over time, as well.

What exactly would be considered a safe loan?

Posted by breezinthru | Report as abusive
 

@Flashrooster,

Please take the following as reciprocal discussion and not a “lecture”. I don’t pretend to know what Mr. Hadas meant, but I gave him the “benefit of any doubt. We don’t want the “perfect” to be the enemy of the “good”, and I think his conclusions were positively inspired…way out in front of his peers on this subject.

You are correct that “…One side refuses to budge on raising taxes and the other refuses to budge on cutting spending.” But I do think the politicians that keep increasing the budgets of their favorite bureaucracies when there is not even the hope of a balanced budget in the near future must bear primary blame.

Our government collects and disburses an obscene amount of money utterly without meaningful prioritization. That is why I don’t feel it prudent to authorize MORE tax revenue until those in charge have shown us that they can use that which we give them effectively.

It is absolutely frightening to see Congress continue to spend more and more without acknowledging the absolute necessity to prioritize the budgetary process. Good money without end is thrown after bad.

Only when “we, the people” come to consensus as to what kind of country we want AND CAN AFFORD will there ever be any limit to the amount of revenue our government will demand. Politicians of neither “side” want that to occur, because they have NO RESTRAINTS on their actions/inactions so long as the status quo prevails.

“The…same stalemate dynamic could very well exist if we didn’t have a quid pro quo system of corrupt governing, and I don’t think corruption is what Mr. Hadas had in mind in that passage. Incompetence? Maybe intransigence? An unwillingness or inability to compromise? Perhaps. But not government corruption. If he was referring to government corruption, he’d probably have written government corruption.” I can agree with you 100% completely if we ignore corruption (other than the effect of lobbying and bureaucratic resistance efficiency and effectiveness) and target obvious “incompetence” and/or intransigence”.

“Something big has to come from the people and we’re a long way off from that.” You used to be less inclined to approve of any kind of serious demand making on the part of the American people.” Actually, I have consistently called for the necessity of the people to make choices of government priorities; and yet, like you, see no way to force the politicians to allow the people a voice in defining their government.

I don’t think anarchy is the answer to anything, but I do agree that at some point “we, the people” may have to shake a 2 x 4 so as to threaten the mules “in charge” such that they remember that they serve at our pleasure TO SERVE US! Yes, “…there will be extremely heavy resistance to ending our government’s corruption…”.

You “…don’t think the worst of it will come from the government. He who holds the wealth is he who holds the power.”

I respectfully disagree here. Our government holds almost limitless wealth and power, but is much like a chicken with it’s head cut off when it comes to effective use of that power.

Individuals who hold “the wealth” are so numerous and fragmented as to their own best interest(s) are, in my opinion, absolutely incapable of acting in concert effectively contrary to the “common good”. But this may be a subject sufficiently fertile for further debate.

Posted by OneOfTheSheep | Report as abusive
 

OneOfTheSheep: Thanks for a thoughtful and well written response. All I would add is in reference to your last paragraph, about which I have to very adamantly disagree, and there is documented history to back me up. Pulitzer Prize-winning journalist Hedrick Smith wrote an excellent book entitled Who Stole the American Dream? that details the history of this organizing that I’m referring to. It’s why we have the type of lobbying system that we have today. Much of it is centered around the Business Roundtable and the affiliates that it’s made up of, like the Chamber of Commerce. Here’s a link to a talk that he gives on his book. It’s long, but well worth it. Of course, the book is better :O) http://www.youtube.com/watch?v=7tLped6GF GA

Of course such a wide diversity of people, organizations, and interests aren’t all organized under one umbrella. There are many organizations that different interests involve themselves in and support. For example, some lobbying firms lobby for several different industries, and some just for one.

Posted by flashrooster | Report as abusive
 

@flashrooster,

“Pulitzer Prize-winning journalist Hedrick Smith wrote an excellent…history of…the type of lobbying system that we have today.” I agree that lobbying as done today perverts our very system of electing and governing.

“Of course such a wide diversity of people, organizations, and interests aren’t all organized under one umbrella. There are many organizations that different interests involve themselves in and support. For example, some lobbying firms lobby for several different industries, and some just for one.”

Which is why I said they “…are, in my opinion, absolutely incapable of acting in concert effectively contrary to the “common good”. My “key words” were “in concert”. That’s not to say that their disconnected efforts do not adversely affect our “common good”. They do. Just not in the predictable fashion necessary to constitute an “organized threat” to anything specific.

That’s why they are so hard to fight! You have exhibited great tenacity in our debates and, over time, convinced me our perceived goals have more in common than conflict.

As your tone has become less “in your face” and each of us better understands the other I have progressively perceived the conviction and reasonable consistency worthy of respect. Few manage that.

I now see I erred in mistaking some of your more “anarchist” comments for adopted goals rather than supreme political frustration. I apologize for prior misjudgments wholly inappropriate.

Posted by OneOfTheSheep | Report as abusive
 

Thank you for a most respectable response, OneOfTheSheep. Certainly no need to apologize. Obviously I, too, can be quite headstrong and stubborn. If there’s been any erring on your part, then I’m equally as guilty. We’ve been meeting at half court.

As you say, our country is faced with a lot of problems. If they are to be successfully grappled with, we can only hope that more people share our passion. See you around.

Posted by flashrooster | Report as abusive
 

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