Tuesday, September 29, 2009

The Bank Job: Part II

In the comments to The Bank Job, which by the way contains our first derivation (thanks Guy!), Dan was wondering, given the fractional reserve system, how do banks handle bank runs. He quite reasonably assumed that they took out insurance which is the smart way to handle high cost, low probability events. The following is my attempt to explain my understanding of the situation.


Your reasoning is quite correct. Insurance against this sort of thing would be prudent, and as long as you were talking about protecting against runs on individual banks, as opposed to the whole system, it could probably be written profitably. But your thinking suffers from a malady with which I am myself often afflicted. I haven’t quite nailed it down, but it’s something like the assumption, “if this is so obviously the way the world ought to work, it must be that way.”


Sadly, its not.


Banks have come up with a much better solution, from their point of view. In the event that they need more cash then they have, they have the Federal Reserve print it. It essentially comes out of all of our pockets through inflation. Now I’m about three books ahead of you in understanding this mess, so I’m no expert either, but here is roughly how it works. If a particular bank is in need of cash, due to withdrawals, they simply borrow it from other banks. If other banks don’t have it to spare, there is one Meta-bank. That bank is the Federal Reserve, which is tasked with being the lender of last resort. Since the FED, simply prints money it can lend all the banks need, completing the counterfeiting cycle by finally printing the cash we’ve all been pretending existed. Of course, as soon as people calm back down, and put their money back in the bank, this new money is considered excess reserves, promptly lent out, and ends up itself multiplied by ten.


Now in the event that a bank is technically bankrupt, that is its assets are less then its liabilities, as opposed to simply being short cash on hand, then it is taken over by the Federal Deposit Insurance Corporation or FDIC (a bank would be technically bankrupt if, for e.g., half the loans went bad, so now there are not enough loans supporting deposits). “A ha! So there is insurance.”


Well sort of. It works a lot like an insurance company, but is not insurance. Banks pay a premium of sorts, that is a fixed percentage of their deposit base. The difference between this and insurance is in the utter lack of even an attempt to avoid moral hazard. As Apos, could explain better than I, its important in any insurance contract that the insured retains some motivation to avoid the catastrophe being insured. For example with car insurance, not only would I hate to get in an accident, but I don’t even want to risk a speeding ticket, for fear that my premium will go through the roof. But with premiums depending only on the size of deposits, banks are encouraged to push risk to the limit to get their moneys worth. It would be like if my car insurance only depended on what the car cost… lets just stay I’d get places faster! If the FDIC insurance were instead allowed to be replaced with an insurance industry trying to earn a profit, risk in banking would be largely reduced, since lower risk would be reflected in higher profits, from lower premiums.


There is another important sense in which the FDIC is different from an insurance company. When the “premiums” are paid to the FDIC, they are deposited in the FDIC’s account at the Treasury. The government then spends the money and replaces it the IOU’s. I know I know sounds crazy! But here is it straight from the former FDIC Chairman William Isaac:


When I became Chairman of the FDIC in 1981, the FDIC’s financial statement showed a balance at the U.S. Treasury of some $11 billion. I decided it would be a real treat to see all of that money, so I placed a call to Treasury Secretary Don Regan:

Isaac: Don, I’d like to come over to look at the money.
Regan: What money?
Isaac: You know ... the $11 billion the FDIC has in the vault at Treasury.
Regan: Uh, well you see Bill, ah, that’s a bit of a problem.
Isaac: I know you’re busy. I don’t need to do it right away.
Regan: Well ... it’s not a question of timing ... I don’t know quite how to put this, but we don’t have the money.
Isaac: Right ... ha ha.
Regan: No, really. The banks have been paying money to the FDIC, the FDIC has been turning the money over to the Treasury, and the Treasury has been spending it on missiles, school lunches, water projects, and the like. The money's gone.
Isaac: But it says right here on this financial statement that we have over $11 billion at the Treasury.
Regan: In a sense, you do. You see, we owe that money to the FDIC, and we pay interest on it.
Isaac: I know this might sound pretty far-fetched, but what would happen if we should need a few billion to handle a bank failure?
Regan: That’s easy — we’d go right out and borrow it. You’d have the money in no time ... same day service most days.
Isaac: Let me see if I’ve got this straight. The money the banks thought they were storing up for the past half century — sort of saving it for a rainy day — is gone. If a storm begins brewing and we need the money, Treasury will have to borrow it. Is that about it?
Regan: Yep.
Isaac: Just one more thing, while I’ve got you. Why do we bother pretending there’s a fund?
Regan: I’m sorry, Bill, but the President’s on the other line. I’ll have to get back to you on that.

Once upon a time, there was indeed a segregated FDIC fund. During the Johnson Administration, someone had the bright idea to put the FDIC into the federal budget as a way to reduce the deficit. This was in the good old days when the FDIC always produced a surplus. Putting the FDIC on budget reduced the deficits being created by spending on the Great Society programs in tandem with the war in Vietnam.

The reality is that there is no FDIC fund. Anything the FDIC lays out to handle a bank failure must be borrowed by the Treasury, which adds to the federal deficit. The total amount of the current outlay is charged against the federal budget even if recoveries are expected in the future, as problem assets are collected by the FDIC. That’s the case whether the FDIC’s nominal balance at the Treasury is positive or negative.


(The above text is an excerpt from a document that used to be here, but has apparently been removed. One wonders if he was asked to remove it. A more charitable possibility is he just couldn't handle all the traffic. Luckily it was so funny I had saved it.)



So at the end of the day the FDIC also gets its funds from the Federal Reserve, or in other words from the rest of us through inflation.



1 comment:

  1. This was a comment I posted under the original Bank Job post, in response to a request for more documentation, on the rather extraordinary dialog between FDIC chairman Isaac, and Treasury secretary Regan:

    Sounds to crazy to be true right. Unfortunately, I'm convinced it is. The only way I can see this being false, is if 1)someone broke into former head of the FDIC William Isaac's consulting company's website, and posted it under his name. Then 2) several reputable people believed it, and wrote about it and 3) no has bothered to debunk it including William Isaac himself. I find this chain of events highly unlikely but within the realm of possibility.

    Unfortunately, Isaac has removed the article from his sight. I'm not sure if this happened when his former company, Secura group switch to LECG of which he if currently Chairman or if he was asked to remove it or what.

    Here is the original link to the article, which will bounce you to LEGC of which Isaac is chairman. :
    http://www.securagroup.com/news/archives/articles/2008/AB080827.pdf

    Here is the Article by Vernon Hill, founder and former CEO of Commerce Bancorp, co-founder of Commerce Bank/Harrisburg (soon to be Metro Bank, Philadelphia), and chairman and founder of Hill-Townsend Capital, LLC of Chevy Chase, Maryland, which originally pointed me to the article.:
    http://www.bankstocks.com/ArticleViewer.aspx?ArticleID=5350&ArticleTypeID=2
    Also on Seeking alpha:
    http://seekingalpha.com/article/95129-fdic-insurance-fund-it-doesn-t-actually-exist

    I was unable to find the full text of the article online, so if you run across is please let me know. I have a paper printout somewhere, but don't have the patience to search through the ~6 unorganized boxes of papers to find it. If I run across it in the future though I'll scan it and put it up. If I recall, his point was that its silly to raise the "premium" on banks in bad times. Since the money is just borrowed when its needed anyway, might as well wait and raise the premiums to make up for the losses when banks are doing better.

    Hope this is helpful.
    Trisco

    ReplyDelete