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.

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