Is the current financial system encouraging risky behaviors for banks?

Recently, I have noticed from newspaper that there have been serious talks all over the world as to how the governments should regulate commercial banks in an awake of subprime mortgage crisis. Everyone agrees on the fact that there should be a financial reform, but don’t agree to what extent.  First, there’s no doubt that financial intermediaries, such as banks, play a crucial role in our society by transferring money from those who don’t need (e.g. you and me) to those who need most (e.g. entrepreneurs). However, I want to approach the issue from the perspective of fractional reserve system, under which banks are required by law to keep some portion of the depositor’s money before lending out to those who need it.  The ratio as to how much percentage banks should retain is determined and regulated by the government institution, called the Federal Reserve. This ratio is referred to as reserve ratio. Are there any problems with this system? The answer is yes.  This is not my idea, but has been illustrated by some economists in the past. It makes sense to me, so I want to share it with you.

Let’s say we only have three banks (Bank A, Bank B and Bank C) in the world, and assume the reserve ratio set up by the government is 10%.  That is, for every dollar deposited to one of banks from people, like you and me, at least 10 cents should be reserved by law in case that either you or I withdraw some money from checking accounts.  Let’s also assume that Bank A and B are “good” banks that lend money only to excellent projects and reserve more than the required 10% to enhance their liquidity.  On the other hand, let’s say Bank C is a “bad” bank that lends money to very risky projects, and only keep the required amount of reserve, 10%.  What happens if people at some point realize that the Bank C is a bad bank and try to take out all of their money in fear of losing it all?  The Bank C is only able to give out 10% of their money at any given time, so it will go bankrupt. This incident may lead people to panic and try to take out all of their money from “good” banks as well. As a result, Bank A and Bank B will go bankrupt, and financial system would collapse.  One bad apple can easily spoil the barrel.  This is referred to as “Bank Run”.  Currently, we have two preventive measures for Bank Run, but they also create other problems.

The first preventive system is the Discount Window operated by the Federal Reserve.  The Fed functions as “a lender of last resort” when a financially troubled institution can’t borrow money from other financial institutions in the market.  The Bank C in this case can borrow money from the Discount Window by putting up its assets as collateral at a higher rate (i.e. discount rate) than market interest rate (e.g. federal funds rate).

What if the Bank C can’t even borrow from the Discount Window due to reasons such as having too toxic and risky assets for the Fed to accept as collaterals?  In this case, there is the second preventive measure for the bank run, which is the existence of the Federal Deposit Insurance Corporation (FDIC).  By paying a small premium to the FDIC, banks can lower the cost of borrowing from you and me significantly. 

For example, if you want to open a bank account, you don’t really need to consider whether or not the bank will go bankrupt in near future because your money is insured by the FDIC up to a certain amount. That is to say, your money is backed by the full faith of the US government. Then, which bank would you go to deposit your money? You would go to a bank that pays the highest interest, regardless of the fundamental economy strengths of the bank. Then, which bank would pay the highest interest?  It is the one that is willing to lend money to highly risky projects to compensate for the high interest rate paid to you. As a result, risky banks are rewarded more in terms of profits, and attract more customers. The problem doesn’t appear when times are good. Companies with risky projects make a good return, and are able to return the interest and principal payments on time. As time goes by, the “bad” bank draws more customers, grows bigger and bigger, and invests the money even riskier projects, and so on. The problem, however, will start to appear and become apparent when the economy turns sour.  The “bad” bank can wreak havoc on the whole society since the risky projects tend to be vulnerable to the economy ups and downs. What’s worse is that it’s really hard for the government to ignore the financial difficulties of big banks because their operations are so interconnected with all parts of our society.

Don’t get me wrong. There are a number of well-functioning big banks with well-disciplined lending practices and policies that have made a huge contribution to the society.  As I said, however, one bad apple can spoil the barrel in the financial world.  In the fractional banking system, banks are so highly leveraged and interconnected with one another that one failure can take down the whole society. The simply, but not easy, way that I can think of to fix is to raise the raise the required reserve ratio for banks in combination of putting back off-the-balance-sheet items to their financial statements.  The other way can be for the FDIC to receive much higher premiums from banks with toxic and risky assets to compensate for the higher risk, as compared to other banks.

Why is economy recovery so slow?

Due to the US housing market bubble bursting and various financial instruments that bet on the bubble, we have experienced an economically difficult time over the last three years.  In economic terms, short-term equilibrium of real GDP has been somewhere below full-employment equilibrium, and the difference is referred to as recessionary gap. 

In attempt to bring the equilibrium point back to full-employment point where long-term aggregate supply curve is located, over the last two years, the government has used 1) expansionary monetary policy and 2) expansionary fiscal policy, both of which attempt to shift up aggregate demand curve.

Let’s look at the expansionary monetary policy.  Simply put, it means making a lot of money available in the market, which gives downward pressure on interest rate.  In theory, if the interest goes down, then the followings will go up:
- Business investment,

- Consumers’ consumption,

- Net exports
If these events occur as planned, it will shift up the aggregate demand to full-employment point.  Then, why are we experiencing such a high unemployment rate and still in this mess?  My short answer is that it takes time.

In theory, business investment (e.g. factories, machines and inventories) will go up since they can borrow money at a low interest rate.  That is, their opportunity cost is low.  However, what are the main reasons that they are willing to invest in the first place?  It is because they have confidence that there will be enough demand for their products in the future, which will make the investment profitable.  If they expect that the recession will last long, then they will tend to hold back their investment decisions until they are certain of economy recovery.

By the same token, consumers will, more or less, react in anticipation of future economy status.  In theory, in the case of the low interest rate, consumers’ consumption will go up due to low future accumulated wealth from saving (i.e. substitution effect). However, people have to worry about whether or not they can work in the near future.  There’s a high probability that they get laid off from their companies in recession, which makes them save more and spend less (i.e. income effect).

What about the net exports?  In theory, if domestic interest is low, then money invested in the domestic market will be taken out to invest in another foreign markets where interest rate is high, which makes domestic / foreign current exchange rate low.  This in turn will make exports cheaper to foreign consumers, increasing the net exports.  Is this the case now?  I would say no for the current market.  The investment uncertainty has been higher than ever before during this financial crisis.  What we witnessed was that people flocked to the safest asset, the US government securities instead of moving away from it.  In addition, the world-wide financial crisis made other developed countries implement the same expansionary monetary policy, which made their interest rate low as well.

If neither consumers nor corporations, then who is the one willing to spend in anticipation of possibly long recession?  The answer is the government.  This brings our attention to the second topic, expansionary fiscal policy.  However, it is subject to debate as to whether it should be done in the form of tax reduction or direct government spending.  There are pros and cons on both policies.  For the government spending, it should be carried out quickly enough to stimulate the economy, and should also be used effectively, which is arguably not the government’s strong suit.  On the other hand, the tax reduction should be implemented in a way that it gives enough incentive to beneficiaries to spend it.  If they hold back the tax benefits for the reasons as in consumers and corporations mentioned above, it will only contribute a little to the expansionary policy.

From my perspective, the occurrences of economy booms and recessions are, to a large extent, attributed to two human emotions; greed and fear.  Whether it be recession or boom, the government plays an important role in an era of high uncertainty when nobody is willing to take the initiative, and the timing is also crucial.  But, it just takes time to take effect for those expansionary policies.  Rather than looking at the situation as the end of the world and holding back their cash in fear, individuals and corporations should also see it as once-in-a-life-time opportunity to invest.