Banks are designed to break, and they do – 03/14/2023 – Martin Wolf

Banks are designed to break, and they do – 03/14/2023 – Martin Wolf

Banks break. When they do, those who might suffer losses cry out for a state bailout. If the costs threatened are large enough, they will succeed. This is how, crisis after crisis, we created a banking sector that is in theory private, but in practice supervised by the State. The latter, in turn, tries to curb the desire of shareholders and management to exploit the safety nets they enjoy. The result is a system that is essential to the functioning of the market economy, but one that does not work according to its rules. It’s a mess.

Money is the material one must have to buy the things one needs. This is true for households and businesses, who need to pay suppliers and workers. That’s why bank failures are such a calamity. But banks are not designed to be safe.

While its deposit liabilities should be perfectly safe and liquid, its assets are subject to maturity, credit, interest rate and liquidity risks. They are good weather institutions. In bad times, they fail as depositors run for the door.

Over time, state institutions have responded to banks’ inability to provide the safe money their depositors expect. In the 19th century, central banks became lenders of last resort, albeit supposedly charging an interest rate. In the early 20th century, governments guaranteed smaller deposits.

Then, in the 2007-09 financial crisis, they effectively put their entire balance sheet in the banks. The banking system as a whole became unmistakably part of the state. In return, capital requirements were increased, liquidity rules were tightened, and stress tests were adopted. Everything would then be fine. Or not.

The failure of Silicon Valley Bank shows that there are holes in the US regulatory dam. This is not by chance. That’s what the lobbyists were asking: Get rid of onerous regulations, they screamed, and we’ll make miracles of growth. In the case of this bank, what draws attention is the bet on unsecured deposits and the bet on supposedly safe long-term bonds.

At the end of 2022, it had $151.6 billion in uninsured domestic deposits, versus about $20 billion in insured deposits. It also had substantial unrealized losses on its bond portfolio as interest rates rose. Put these two things together and a race is likely: the rats will always abandon sinking financial ships.

Those who fail to escape in time will scream for help. It might be amusing that the ones calling for the rescue this time are Silicon Valley libertarians. But few people are capitalists when threatened with losing money they thought was safe, and no one is better than a capitalist at explaining how their wealth is essential to the health of the economy. Uninsured depositors were duly bailed out at the SVB and elsewhere. This removes yet another source of private sector discipline on banks.

However, SVB was only the 16th largest bank in the United States. That is why, after all, it was left out of the regulatory network applied to the most systemically important banks. It was conveniently unimportant in life but became systemically important in death. The Federal Reserve has also offered to lend at face value to banks in need of liquidity.

These are negative “haircuts” — call them “hair grafts” — for banks in need of emergency loans. In addition, President Joe Biden stated that “we will do whatever it takes”. It is true that this time shareholders and bondholders are not being bailed out. Furthermore, losses are supposed to be borne by the banking industry as a whole. However, losses are again partially socialized. Does anyone doubt that socialization will deepen if the crisis does too?

Naturally, people wonder what this new shock means. Some analysts believe the Fed will not tighten monetary policy further this month. What is clear is that there is a lot of uncertainty, which could justify the delay in further tightening. But curbing inflation remains essential: the US consumer price index rose 6% year-on-year in February.

Right now, however, the big question is not what will happen to the economy, but what will happen to finance. One bright spot is that fear has reignited in the financial system. The anxiety created by small shocks makes major crises less likely. There are other lessons: Banks remain as vulnerable to runs as ever, and like it or not, uninsured depositors will not be wiped out in a bankruptcy. Confidence that deposits are safe is very important, economically and politically.

So how might this new evidence of the extent to which the state supports banks, even in relatively normal times, be reflected in policy? A simple answer is that regulation of systemically significant banks should be extended to the entire system. Another is that deposits should be placed above all other debts in an insolvency, to reflect their social and economic importance. Another is that balance sheets should always reflect market realities. Finally, capital requirements must be adjusted accordingly. If banks’ capital falls too low, in market valuations, it must be increased quickly.

The fundamental lesson we have to relearn is that, even in a modest crisis, deposits cannot be sacrificed and rules about haircuts for liquidity provision will be scrapped. Banks are state-owned partly because they are at the heart of the credit system, but even more so because their passive deposits are politically important. The marriage of risky and often illiquid assets with liabilities that need to be safe and liquid within undercapitalized, profitable, bond-paying institutions, regulated by politically subservient and often incompetent public sectors, is a calamity ready to happen.

Banking needs a radical change. Next week I will discuss how to deliver this.

Translated by Luiz Roberto M. Gonçalves

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