A little bit more on Cato’s 15 years of financial deregulation.
Matt Yglesias takes a closer look at the pre-crisis Cato arguments against the CRA. Dismantling the CRA has long been a goal for Cato,going back to the very first financial reform policy document I can find online (1995). Sure enough, in 2003 the argument was: “Finally, by increasing the costs to banks of doing business in distressed communities, the CRA makes banks likely to deny credit to marginal borrowers that would qualify for credit if costs were not so high.” Which is to say, it’s keeping people with huge credit risks from getting mortgages. Ummm, nice job CRA? I like how that talking point has changed overnight for the right.
Back at Netroots Nation 2009, Chris Hayes was on a panel with the Roosevelt Institute’s Rob Johnson and Chris noted:
Think about FDIC, how would we design FDIC today?…What we would do is, we wouldn’t set up an independent government agency which works very well, has worked smoothly, has prevented bank runs, since the bad old days of bank runs…we wouldn’t do that today. The banks would be like ‘what? you are just going to step into this market?’ What we’d do today if we were designing FDIC is we’d choose a bunch of the banks and we’d subsidize them insuring other banks…This is a massive conceptual problem.
Yup. And here’s Cato in (1997) saying the same exact thing, that we could create some sort of “individual bank mandate” to purchase private deposit insurance:
Congress could easily expand the use of contractual regulation. For example, it could require all financial services firms that accept deposits, provide insurance, or directly access the payments system to negotiate a “safety-and-soundness” contract with a private-sector entity that would monitor the financial services provider’s compliance with the terms of its regulatory contract and protect depositors and insureds against any loss should Hie financial services firm become insolvent. Such a contract would specify the prudent practices to which the firm would agree to adhere in order to operate in a safe-and-sound manner. The monitoring firm’s fee undoubtedly would be risk sensitive, reflecting the financial institution’s probability of failure. The private sector could easily assume this most important function, which government bureaucrats have performed badly.
The funny part is that this scheme of “banks insuring other banks” has a terrible track record; I bet nobody can point to a successful implementation of it. When it fails how credible is it that the government will let the economy collapse?
Also what they wanted in the 1990s on FDIC would have given a huge amount of power to the ratings agencies over our commercial banks, who would have been the likely people to step in and get paid by the commercial banks to give ratings to the commercial banks. And as we found out in 2008, the moment when these “safety-and-soundness” contracts would most likely be called in for collateral calls is during a crisis when nobody is credible to actually pay them out, creating panics, which perpetuates itself.
Only the government is credible to step into this situation, and having a clear rule of cutoffs for how depositors will and will not be covered is the appropriate way to do it.
It’s not clear to me how grandma with $15,000 in her checking account is going to keep large national banks in check, but if one is freaked out about “moral hazard” of you not worrying your liquid savings disappearing in a panic (ie – when you need it most) there are haircuts and other neoliberal ways to adjusting this. I’m not worried about this, but if you are there are ways to go about it – that’s not what they are suggesting. They want it completely gone.
If I came up with a scheme that would reintroduce “polio” into our daily worries you would find me not credible. Why are we entertaining solutions that would reintroduce “commercial bank runs” into our daily worries? Finding a solution to this is one of those things we got right in the 20th century. Figuring out a way to solve the “capital shadow bank runs” is what we should be focused on, not reintroducing old problems.
This one is really fun. Cato (2001):
Federal deposit insurance is a tax on bank deposits that forces consumers to involuntarily purchase unnecessary government-provided insurance at government-set rates. Born of the Great Depression as temporary legisla- tion later made permanent, government deposit insurance was intended to maintain consumer confidence and prevent bank runs, but modern financial institutions are better diversified and less at risk than were finan- cial institutions during the Great Depression….
The last time major bank runs occurred in the United States was during the months before FDR was inaugurated. Depositors, speculating that FDR would devalue the dollar against the gold standard to inflate prices, raced to withdraw funds and convert dollars into gold coin and bullion at the old rates…
Financial innovations have also allowed banks to reduce risk. Banks can hedge with derivatives against abrupt changes in interest rates that would otherwise adversely impact bank assets. Sophisticated financial models enable banks to purchase portfolio insurance. Financial instruments can protect spreads and limit risk from mortgage prepayment. Today’s banks are less at risk because they hold pooled mortgage-backed securities. Small banks of yesteryear borrowed short from depositors and lent long, holding the local home mortgages they originated to term. Their assets were composed of illiquid and geographically undiversified loans, which made it difficult to raise cash if needed to finance depositor withdrawals…
The probability of a banking panic is more remote today because of innovations in the banking industry, not because of the FDIC and mandatory government-run deposit insurance. There is little reason to expect systemic depositor withdrawals. In fact, slow withdrawals isolated to substandard banking institutions in small doses are beneficial to the health of credit markets. Deposit insurance, meanwhile, increases moral hazard, because not-at-risk depositors have
little incentive to steer their funds away from unsound and ailing banks that promise higher returns toward sound and healthy banks. Instead of private markets gradually stopping the flow of funds to inefficient financial intermediaries, government is left in control to abruptly end a bank’s operations after a misallocation of capital that otherwise might never had occurred.
Sorry for the long quote but:
1. They blame FDR for the last banking crisis.
2. Banks today, in 2001 that is, will never have a financial crisis because:
a. They hold mortgage backed securities.
b. They have exposure to the entire country in mortgages (geographically diversified) and there’s never been a nationwide housing bubble.
c. risk management has evolved so they know what they are doing. “Sophisticated financial models enable banks to purchase portfolio insurance” is wonderful in a post-AIG world.
d. implicit in their argument is that “shadow banks”, which borrow from credit markets instead of from depositor are more reliable because they are more liquid (and they are more liquid because they can panic quicker as we found out!).
3. They note how well this depositor funding market has worked post-war but assume away the government or FDIC is a part of that success.
Happy days are here again; we’ll never have a wave of commercial bank failures in our real economy in the 21st century because of things like value-at-risk and monte carlo simulations.
Lots of people called things wrong, but that’s exactly the reason we want a government that acts as a risk-insurer of last resort. You shouldn’t go bankrupt because you fall off a ladder. You also shouldn’t force a banking run because you are suddenly worried about what could be in the books of your bank, setting off a chain reaction.