Finance

This time is different. But is it?

“On the 16^th of March, a major bank narrowly avoids bankruptcy by its sale to a former rival at the shockingly low price.”

Sound familiar? The March in question was March 2008, the bank was Bear Sterns, and the rescuing firm was J.P. Morgan Chase, which acquired Bear at $2 per share in one of the opening acts of what became the global financial crisis of 2008.

Fifteen years later, markets are once again rattled by fears of contagion. In just a few days, three regional lenders failed in the US, as the contagion spread to systemically important banks in Europe. Credit Suisse had to be taken over by its rival UBS during the weekend of 18-19 of March 2023. Days later, markets started turning on Deutsche Bank, as the SEC issued a warning about a hedge fund.

Austerity for ordinary citizens and bank rescues for the affluent is a toxic mix

Not even ChatGPT could dream this up: Fifteen years after the whole world financial system collapsed and barely a decade since we were told the Dodd-Frank financial reform bill fixed the problems in the US system, two major regional banks in the U.S. are down and depositors are fleeing from many, many more.

The explanation of systematic breakdowns in supervisory oversight over time must include the shift in Federal Reserve culture during and after the 1990s

The closing of Silicon Valley Bank (SVB) on March 17 began a series of extraordinary steps taken by key supervisors of the global financial system (United States, United Kingdom, and Switzerland), all of which tell us that we are not living in normal times. From the US Treasury’s approval of a “systemic risk exception” for SVB, thus allowing a blanket government guarantee of all its deposits, to the precedent-setting rescue of all deposits at Credit Suisse, ordinary understandings of the law were stretched to and probably beyond their limits.

Bank failures don't threaten most deposits, but they do threaten jobs

At the last FOMC press conference, Fed Chair Jay Powell assured us that “all depositors' savings and the banking system are safe.” The failure of Silicon Valley Bank less than two weeks earlier had started a debate about whose deposits were safe. Specifically, whether deposits greater than $250,000, which are not FDIC insured, would be protected like the smaller, insured deposits. In the end, Silicon Valley and Signature Bank, which also failed, were deemed systemic risks, so all depositors received their money.

A federal government guarantee or 100% reserve banking? Which is better?

Not long after arriving to teach economics at Colorado State University nearly four decades ago, I was introduced to a retired economist living in Fort Collins who had a simple idea for solving the problem of bank runs: require banks to have the cash on hand whenever the depositor wished to withdraw. Lloyd W. Mints had been one of the founders of the Chicago School of Economics along with Henry Simons and Frank Knight. The proposal, which has a history going back to at least the early 19th century, has variously been called 100% reserves, full reserve banking, or the Chicago Plan for Banking Reform.

There is a banking crisis. Again. Banking regulators were asleep at the switch. Again.

The present crisis is not a replay of 2007-08, which was centered around housing. In that crisis, lenders took on too much credit risk. Additionally, financial institutions relied on exotic financial products to protects, such as derivatives, to protect against risk. The products failed to do so. Lawmakers and regulators reacted by placing new constraints on credit risk.

Thomas Hoenig, former President of the Federal Reserve Bank of Kansas City and former Vice-Chairman of the FDIC, argues that “Another Banking Crisis was Predictable.” In response to the last banking crisis, the Fed’s risk models were focused on credit risk, while Silicon Valley Bank’s portfolio was heavily exposed to interest-rate (“duration”) risk. Once the Fed began hiking interest rates, the value of SVBs assets began falling.

There needs to be a safe place for businesses to place their reserves and working capital

There are five main causes of the SVB collapse and the subsequent knock-on problems facing the US and global financial system: the Federal Reserve’s anti-inflation obsession causing it to raise interest rates too high and too fast; the inherent fragility of banking which for centuries has periodically erupted in crises; inadequate regulation of this fragile system which often leads to high profits that accrue to bankers’ and their wealthy owners; the corruption and self-dealing that often result from banks’ insufficient supervision; and the lack of public alternatives for financial institutions and services that could perform many of the key functions of banking and finance with less risk and without the private financiers taking their cut. Some of the huge profits the financiers make from this system are funneled back to buy support from the politicians to prevent adequate regulation, and to secure bail-outs when the system crashes.

Morale hazard can turn into a darker ‘moral’ hazard

Our current banking crisis -- and our government’s responsibility for and response to it -- underscore risks facing citizens and taxpayers backing up our banking system.

Government programs like deposit insurance and the Fed’s role as lender of last resort have been sold as “stabilization” schemes. But we are learning again some unlearned lessons from the past. Those lessons relate to two of the most important words in finance -- moral hazard.

Insured parties may take more risk, once they are insured. This isn’t necessarily immoral, just rational behavior reacting to the fact that they have insurance.

But at some point, ‘morale’ hazard can become ‘moral’ hazard, particularly if depositors and other creditors of banks are protected by the government and the public purse. Protected parties and their friends in high places may become willfully blind to downside consequences imposed on others, and use the government as a vehicle for gain for well-connected insiders while losses are socialized.

In the following conversation, law and economics expert Walker Todd explains how a financialized system creates havoc and why it’s time to rethink banking

Over the last two weeks, you could hear rumblings under the global financial system as one large, ugly crack appeared after another. Soon everybody was bracing for an earthquake.

We have just witnessed the second and third biggest bank failures in American history, putting the health of the financial system on high alert. Events have sent global markets reeling with fears of fallout not seen since the 2008 financial crisis.