Skip to comments.Discuss how to restructure the banking system to allow banks to fail gracefully. (Vanity?)
Posted on 07/30/2010 12:48:48 PM PDT by Norwegian Libertarian
I need some help sorting through some ideas I have concerning the reason the banking system needs bailouts, and how to restructure it so that it won't. I also want to discuss how best to disperse the resulting proposition/argument.
The root of the problem, as I see it, is that the banking system is fundamentally unsound. This because, while a bank holds assets backing its liabilities, the maturity of those assets (several years in the case of morgages) far exceed the maturity of the banks liabilities (zero/instant).
In effect, the bank is backing fully liquid liabillities with illiquid assets, meaning that not even a sound bank can withstand a bank run if it can not find buyers for its assets on reasonable terms. This has traditionally been solved with the lender of last resort policy, guaranteeing that the fed will supply a bank with printed money in the event of a bank run. Forgetting for a moment the effects this has on the money supply, this policy entails a public guarantee of deposits, as the fed will be taking the loss if the banks assets don't pan out.
This leaves a moral hazard in which banks are able to speculate with public money, in a private upside public downside format. That in turn necessitates a gargantuan system of regulations and oversight, governing how much a bank can hold of various assets determined by their ratings.
The failiure of the ratings agencies entail the failiure of regulation, and with that the failiure of the entire system. The lefties are correct in stating that it needs to be reworked. I do not however have any faith that their reforms will do anything to address the core issue.
The system I imagine replacing the current banking system is one in which the banks, rather than issuing account balances, issue bonds with maturities at least equal to the assets backing them. Each bond issued by the bank would be sepparated into tranches, virtually assuring payment on maturity of the lower tranches, thus they should be easily sold in financial markets (they should be decidedly non-toxic). These tranches could perhaps also be insured by the bank?
I'm not sure wether to let the bank raid assets with later maturities to pay insurance for mature bonds, I'm thinking leave it to the market. (Let depositors decide what they prefer)
I'm also considering a sepparate liquidity insurance, where some company, perhaps a sepparate division of the bank itself, guarantees to buy the bank-issued bond for an agreed price as a function of time. The asset could then be used as a bank account balance, but would still leave a sound tradable structure in place in case of bank failiure. I am not sure this is a good idea though, I would need to better understand the impact on monetary policy.
What I hope to achieve by all this is to make deposits in a bank whose soundness is in question behave more like the stock market, where an owner has to either wait for the stocks to pay dividends to get his money's worth or find someone willing to take the stock off his hands. The stock market, unlike the banking system, can absorb losses without failing, and this is what I wish to replicate in the banking system.
Please don't hesitate to ask for clarifications if something is unclear, I've not completely hashed this out, and both my presentation and the thoughts behind it still need work. And please don't hesitate to comment or provide ideas of your own.
Remember, I'm only trying to codify restrictions on bank deposits that are found in reality, The house used as collatteral for a mortgage cannot suddenly metamorphosise innto consumer goods because the depositor wants his money instantly. I think this mismatch between fthe financial instrument and reality is what causes banks to be so fragile.
But first, I need your help to sort them out.
How to solve the banking problems in three easy steps...
1) Eliminate ‘insurance’ on all bank accounts, as served by the federal government. All it really becomes is a special tax, with free money for people if a bank goes south.
2) End banking regulation. People are shocked when their bank closes, because, well, isn’t it regulated? Whereas if they /knew/ it was unregulated, and uninsured, they’d spend considerably more attention upon choosing and maintaining accounts, as who’d want to do business with a bank that’s just a glorified gambling establishment?
3) A home loan that is not current should count as a net zero asset until it is sold. Presently, because of regulations, banks are hesitant to let properties go, as when it’s sold, the value is refixed, and they’ll have to actually show all the loses that they are facing. It is unnecessarily inflating the housing market, preventing recovery, and forcing tens of thousands into rental properties where they could be buying their own home.
The problem is regulation and government manipulation of the market. Let the banks that need to fail, well, fail, and let those who are actually strong shine, rather than being in the crowd of me-toos who are held up only because they’ve a huge inventory of bad loans and foreclosures that are counted as assets rather than liabilities.
Any entity that put money into bad investments simply needs to go under. Even if that entity doubles as a regional Federal Reserve Bank.
We can much more easily handle the fallout of selling off assets than what results from propping up stupid businesses and banks and allowing them to come out largely unscathed.
I was against TARP and everything else from the beginning. All it’s all done is indebted us further to China, while bolstering 0bama’s special interests.
The natural capitalistic system is boom and bust, building from the ashes of failure.
The strength of our system was its ability to fail and start over again. Anything that slows down collapse and extends dying companies or ideas or debt, etc. inevitably makes the eventual collapse bigger and harder to recover from. A good analogy is preventing forest fires to preserve forests. It sounds good initially, but the end result is dead forests or forests that in burning sterilize the ground and take decades to recover.
A healthy economy or ecosystem is one with constant failures and fires. The goal shouldn’t be to prevent bank failures, the goal should be to make it extremely easy for banks to fail and to make the investors personally responsible to cover the failure.
I agree, but if we drop the lender of last resort function of the fed, and remove the federal guarantee of bank accounts, we need some other function in order to discourage bankruns.
That’s what I want to discuss in detail, my idea is to have bank deposits themselves be tradeable assets with maturity dates. That way, if a bank’s status becomes scetchy people either have to ride it out or find someone to buy them out. It would work like the stock market, in that if there is a loss of conficence, the price immediately drops, and people can either wait it out or sell out at a small loss. The alternative is a stampede to withdraw ones funds, and the last man to the bank looses everything.
I agree on all points, what I am trying to get across are ways to go about doing this. In short my observations are as follows:
1) The banking system is fundamentally unsound as it promises withdrawal of funds at any time, but backs this promise by assets that pay dividends over time. The financial instruments (bank accounts) should reflect this reality.
2) Therefore the banks should present customers with tradable bonds issued by the bank rather than accounts which can be emptied at any time. Ordinarily these bonds would trade as risk free bonds, and thus fetch a fixed price rising at the rate of interest as the maturity date approached.
3) In the event that the bank should crash, you will now be left with an orderly bond market of slightly higher risk bonds, which can still be traded. Losses that cut past the equity of the bank and into the deposits would affect the deposits like a worsening economy affects the stock market. Prices would adjust to reflect expected yield, and there wouldn’t be a musical chairs style rush to the bank.
Think of it as an alternate way of handling bank bankruptsies. And it even works before the bank is bankrupt, by allowing risk averse depositors to sell out at loss to less risk averse investors.
This beats the ‘last man to the bank pays the bill’ game that the current system produces.
Again, this is not an attempt to prop up failed banks (I have no idea why people here seem to think that’s what I’m about), it is an attempt to fix the way they fail so it happens in an orderly fasion, allocating losses without the need for drawn out bankruptsy proceedings.
Banks already have trade able bonds, they call them CD’s.
The reason banks are failing has nothing, zip, zero, nada to do with people withdrawing money from the banks. The sole reason banks are failing is that they made bad loans. They have a lot of excuses for why they made those bad loans, but that is the bottom line. Banks have more debt than assets, they are broke and the only reason they are still in business is that the Fed has been lending them gobs and gobs of money, which they are now lending to the government.
Once again I agree, but the only reason people arent racing eachother to the banks is because their money is guaranteed by the federal reserve. If we are to remove that guarantee, which I think we should, then we need a better way to handle the resulting fallout. Again, I’m not looking to bail the banks out, only restructure the banking system so that it reflects that the assets are long term ones.
The Certificate of Deposits are pretty much exactly what I had in mind, though if the bank could not back CDs with assets of longer maturity than the CD, there would need to be CDs of longer maturities than mentioned on Wikipedia.
That helped, thank you.
If we now assume a bank whose issued CD’s are all of equal or longer maturities than the assets backing them, and are tradable on an open market, we pretty much have what I have imagined. In the event that a bank should begin to look shaky (not having quite failed yet), the value of it’s CD’s would drop slightly, and risk averse depositors could sell ther CD’s to less risk averse depositors. This would help the economy by allocating possible losses to people or companies who can bear them (along with the associated higher expected yield).
Perhaps we can advocate for a class of CD only banks, subject to less regulation, whose CDs are of equlal or longer maturity than the assets backing them. These banks would not be insured by the fed, and would be excempt from any insurance related tax. Divide the CD’s into tranches and you have a fully free market alternative to the current banking debacle, while still supplying equally secure investments in the lower tranches.
All that remains to be figured out is how make your CD holdings accessible by debit card. Ie one should be able to sell arbitrary amounts, on demand, when charging to a card, with some backup solution, like short term credit, kicking in if the price was depressed for any reason.
I’m liking this idea more by the minute.
The problem isn’t matching the duration of the loans to the deposits.
The problem is that the value of the loans is in reality about a third (probably less, maybe much less) of the deposits.
Let me give you a very simple example: The bank receives a long term deposit of 300k, then they lend that out on a mortgage for 300k, then the realestate market tumbles because the population isn’t growing and the housing market is grossly over built. The borrower then walks away from the house because it is grossly underwater, leaving the bank with an abandoned house in a deserted neighborhood.
Now the bank owes 300k plus interest on an asset worth 100k if it is lucky. If this is representative of the banks holdings the Bank is now bankrupt (interesting word) it doesn’t matter that the bank doesn’t have to pay off the debt for 30 years, the bank should be closed down at this point. The longer the bank continues to operate and lose money the worse the situation becomes.
What has happened is that we have a ponzi scheme with the government now depositing money into the banks in the vain hope that the people that walked away from their upside down mortgage will come back and start making payments.
The bottom line is that without inflation, the whole system comes crashing down, eventually. The only question is how this crash is going to work itself out. I haven’t got a clue.
I understand that the banks are broke. And as I imagine the system, CD’s would now trade at discount prices reflecting the expected returns (safest tranches would still be untouched, riskiest tranches would trade at firesale prices). As they mature, people get paid the full dividend untill the bank is out of equity, and then the return of the bonds with the matching maturity after that.
The point is that if you have neither this maturity system, which i propose, or the federal guarantee of deposits, which we currently have, you would have people storming banks like headless chickens at the first sign of trouble. This setup is bankrun proof, it would react more like the stock market, and less like the withdrawal derby.
Wanton bankruns is why the federal guarantee was introduced in the first place. This is my idea for replacing it.
Avoiding the fire-sales that should be happening, the ultra low price real estate that should be on the open market right now, should tell you something.
This is a system designed to keep certain people rich. And the rest decidedly out of the loop. It is not a system that even considers people who can't find safe havens for capital but might find bargain real estate interesting. This is fast becoming, or already is well beyond a free market.
It's a good time to consider what banking should really be. Our country, our free enterprise system, and our future depends on our banking system.
And we've never gotten it right yet.
It's a good time to consider what banking should really be. Our country, our free enterprise system, and our future depends on our banking system. And we've never gotten it right yet.I agree. So what do you think of my idea as it currently stands? I propose ditching bank-accounts as they are currently implemented, as they are to conductive to bank runs and other mayham, and instead have banks sell CDs with maturities no shorter than the assets backing them. The CDs would be tranched rendering the senior (most secure) tranches virtually risk free. The tranches would be split into shares (1 dollar each on maturity parhaps? or 1 cent?) and tradable on a market similar to the stock market. Possibly debit cards could be made to access funds by selling shares in senior tranches, thus making them effectively as liquid as bank accounts currently are. The benefit of such a system is that it would allow a bank to continue to function even if doubts were raised about its possition. A bank that suddenly is percieved to have a 10 % chance of not being able to cover all of its deposits, with a 3% shortfall expected for depositors in that event, would nevertheless experience a bankrun under the current system. Under my system the expected return on the most junior tranches of the CD's furthest from maturity would imediately loose value reflecting the reduction in expected returns. Holders of shares in those tranches would have to either sell out at a small loss, or bear the increased risk. Basically it would work like a low risk version of the stock market, with the senior tranches bearing virtually no risk at all.
I have no Idea what happened to my paragraphs.
I agree. So what do you think of my idea as it currently stands?
I propose ditching bank-accounts as they are currently implemented, as they are to conductive to bank runs and other mayham, and instead have banks sell CDs with maturities no shorter than the assets backing them.
The CDs would be tranched, rendering the senior (most secure) tranches virtually risk free, and then split into shares (1 dollar each on maturity parhaps? or 1 cent?) tradable on a market similar to the stock market.
Possibly debit cards could be made to access funds by selling shares in senior tranches, thus making them effectively as liquid as bank accounts currently are.
The benefit of such a system is that it would allow a bank to continue to function even if doubts were raised about its possition.
A bank that suddenly is percieved to have a 10 % chance of not being able to cover all of its deposits, with a 3% shortfall expected for depositors in that event, would never the less experience a bankrun under the current system.
Under my system the expected return on the most junior tranches of the CD’s furthest from maturity would imediately lose value reflecting the reduction in expected returns. Holders of shares in those tranches would have to either sell out at a small loss, or bear the increased risk.
Basically it would work like a low risk version of the stock market, with the senior tranches bearing virtually no risk at all.