Real World Economics: Making the case for bank regulations

Edward Lotterman Financial intermediaries that channel money from businesses and households desiring to save to others desiring to borrow perform a vital economic function Such flows of funds can facilitate great creation of wealth that can benefit all Indeed much of the prosperity that we in the United States historically have enjoyed stems from sophisticated and effective privately held banks and financial markets that on the whole have allowed capital to flow to where it is the bulk productive Aside from creating the fiat currency establishment need not be involved to a point Unfortunately such intermediation invariably involves vulnerability Loans from one small saver to a small borrower put the saver s money at vulnerability They require time and effort to monitor The same is true for rental properties or ownership shares in other businesses That is precisely why private banking and outlay firms handling savings loans stocks and bonds developed They have economies of scale in assessing exposure and in monitoring borrowers or businesses in which stakes have been purchased So savers and investors large and small can deposit money in a bank that thus handles hazard assessment and monitoring However this does not end the hazard Banks inevitably still make various loans that are not repaid Specific investments don t pan out These defaults may be due to circumstances entirely beyond a borrower s control such as a farmer losing all their crops to hail Or a bad business model The loss may be ascribed to poor judgement but with no bad intent And then there may be actual fraud unlawful acts whether premeditated or impulsive Regardless of cause however banking systems could not function if any one bad loan or set of loans instantly translates into depositors being exposed to loss Bank owners must have various of their own capital in their business and that equity grows over time This owner equity serves as a cushion When a loan is not repaid all deposits are still covered The bank s assets remain greater than its liabilities and it is solvent at least as long as bad loans are less than the bank s capital reserves However solvency is not the only peril There also requirements to be liquidity While bulk deposits are demand deposits checking or savings accounts that can be emptied without warning specific may be in the form of certificates of deposit from which money cannot be withdrawn without penalty before a contractual amount of time passes Regardless of how safe the loans made by the bank are if a large number of depositors demand to withdraw their funds the bank will not be able to come up with cash to satisfy them The bank is solvent Its assets do exceed its liabilities But it is not liquid This was the situation for fictional banker George Bailey in the film It s a Wonderful Life and countless movies and books about the Old West or the Depression era Without any lender of last resort to tide a solvent but illiquid bank over a emergency a bank would fail A few depositors would at best get their money out only over time as the failed bank s outstanding loans came due and were paid off This occurred majority of of late during the mortgage dilemma of the late s Capital was invested in real estate loans predicated on the fallacy that the underlying collateral could only rise in value When home prices tanked it set off a chain reaction that toppled particular of the bulk storied global stake banks and lenders The lenders of last resort in this occurrence was the U S Treasury and Federal Reserve But this has been true for greater part of our nation s history In the wildcat banking era two centuries ago there were multiple states in which nearly anyone could open a bank Not only could these accept deposits and make loans with virtually no oversight they also could issue their own paper currency bank notes that were supposed to be redeemable for silver on demand Often they were not With little control over who opened a bank and virtually no supervision afterward putting money in a bank was fraught with danger Moreover it was dangerous for any person or business to accept payment in paper money about which they had no idea of its underlying value This lack of information was an enormous drag on the commercial sector Over time regulation at the state and then federal level grew But as in the last few days as a century ago before the Great Depression nearly a third of all households lost various money in a failed bank The basic trouble in academic economic terms is that information is incomplete not available for all relevant issues It also is asymmetric with one side having more knowledge than the other That is not just true for banks The same information problems appear in all other financial intermediation stock and bond markets mutual funds and the rest Lack of reliable information is like ground glass in a gearbox In the old days why would someone buy a bond if they did not know whether the canal or railroad or steel mill it was funding would certainly generate enough profits to pay interest and principal promised In the modern era what about buying cryptocurrency where the intrinsic value is based solely on the demand for crypto Should one buy into certain hedge fund making investments in private credit or private equity if the buyer really doesn t understand what collateral these represent and only knows that the returns are high Can private industry forces generate the needed information Yes to a point In the s telephone-book sized quarterly reports detailed the varied relative values in silver of paper money issued by different banks It took money to compile such directories but these did not sell well if they proved inaccurate Selling them generated revenue but they were easy to pirate In the modern day companies with accounting expertise meticulously go over the financial statements of corporations or authorities entities issuing bonds or offering shares of stock These firms assign ratings from AAA on down As with the bank-note rating companies bond-rating companies were vulnerable to plagiarism so issuers of the bonds have to pay The fact that ratings make it easier to sell bonds and at lower interest rates motivates issuers to pay for the arrangement But such ratings have long not been mandated by regime But a lack of privately compiled objective verifiable financial information compounded by severe financial and economic crises motivated regime action The Panic of let to creation of the Federal Reserve The collapse of financial markets and thousands of bank failures after the Wall Street crash eventually brought about the New Deal federal regulation of lenders securities exchanges and federally administered insurance of a few deposits As with a multitude of things however regulation began a whack-a-mole event that continues in the modern day with financial firms searching for loopholes or creating new accounts resources funds or securities that skirt regulation Moreover a populist political mindset opposed to regulation further compounds the threat Does profit motive and likely region share force private markets to behave It is not cynical at all to note that the opposite is true these actors will misbehave if given the chance Consider how collateralized mortgage bonds bundled with other debt was all the rage years ago with disastrous results Now largely unsupervised funds invest in private loans or in private equity stakes especially betting on the industry anticipated of new high-tech startups remember the dot-com bubble of the late s These may turn out to be huge long-term moneymakers supplanting similar rivals as the region shakes out think Facebook vs MySpace But the losers may turn out to be like unexploded ordnance from World War II in European cities unseen but with fuses that may explode with just a minor vibration Related Articles Real World Economics Cavemen didn t need banking regulations we are not cavemen Real World 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