Barry Ritholtz Mistaken on FDIC

Does the banking industry operate under the confines of genuine capitalism?

For the contemporary leftist thinker, the financial crisis was caused by the imprudence and recklessness of Wall Street.  The lack of government regulation over such instruments as subprime mortgages allowed the Street’s greedy ambitions to run amok.  The casino-like risky lending which dominated the industry’s operations culminated in the worst economic downturn in nearly a century.  Taxpayers were then forced to pony up for Wall Street’s despicable gluttony for immense riches.  Hence the need for all-knowing, all-powerful government regulators untainted by political biases to police the sector.

Or so the popular narrative goes.  There is no doubt the “greed is good” mentality afflicted Wall Street during the run-up to September 2008.  The same train of thought drives not just financial wheel-dealing but all economic transactions at every point in time.  It is in man’s nature to act with purpose.  What leftist egalitarians and fairness fighters call greed is simply men, regardless of economic standing, attempting to achieve their subjectively desired ends.  In the proper understanding of free markets, voluntary transactions are necessarily a positive sum game.  Exploitation occurs only when coercion or fraud is employed; that is when government violently interrupts the market process by erecting barriers to entry and delegating how business should run.

And exploitation is precisely what modern banking is about.  At few points during the history of the United States was banking totally unregulated by either state or the federal government.  Inflationary credit expansion, laws forbidding branch banking, and legal tender laws all contributed to financial panics throughout the 19^th century.  It was the government’s intervention with laws such as the National Bank Acts that created the conditions for expanding the overall money supply beyond the accumulated supply of gold.  This environment all but ensured the legal right would be granted to banks which would allow them to renege on “their contractual obligations in times of difficulty by the legal suspensions of cash payments to their depositors and note-holders” according to economist Joseph Salerno. With the emergence of the Federal Reserve as a “lender of last resort,” moral hazard was firmly implanted into the psyche of the banking industry.

Acclaimed financial blogger Barry Rithotlz recently discovered (or at least outright acknowledged) that modern day banking is completely removed from an industry operating under private gains and losses.  In an effort to squash the threat of “too big to fail” banks once again bringing down the global economy, the purveyor of the Big Picture blog penned a fictional letter where the chairman of the Federal Deposit Insurance Corporation informs an anonymous banker as to newly adopted operating restrictions set forth by the bureaucracy:

Following the most recent bank failures, the Federal Deposit Insurance Capital Reserves have fallen to perilously low levels. This pool of capital is the guarantor of public monies deposited in demand accounts in the actual bank divisions of your firm. We cannot sit idly by while this becomes exhausted due to your speculations, thus putting taxpayers monies at great risk. Nor can we assume unlimited liability in guaranteeing deposits at firms that were once depository banks but now have morphed into giant derivative trading casinos with potential liabilities measured in the trillions of dollars.

Therefore, as chairman of the FDIC, with the full support of my Board of Governors, we have decided upon the following changes:

1. Effectively immediately, we have increased the FDIC deposit insurance for any US bank that engages in ANY trading of derivatives or underwriting securities or other investment banking activities by threefold. This 3X fee increase goes into effect immediately. It applies regardless whether these trades are hedges for proprietary trades or are made on behalf of clients.

2. Effective in 90 days, we are LOWERING the insured maximum insured deposit liability to $100,000 per account for derivative trading firms. Effective in 180 days, the insured maximum insured deposit liability drops to  $50,000 per account.

3. Effective in 1 year from today, on May 23, 2016, we will no longer offer deposit insurance for any firm that engages in derivative trading, underwriting securities or engages in Investment banking.

4. Any bank with fewer than 10,000 depositors or less than $5 billion in assets may apply for a discretionary waiver of these rules.

Sure enough, the measures Ritholtz is in favor of would help alleviate Joe Taxpayer’s burden in being forcefully compelled into providing universal deposit insurance.  But for someone who wrote the indispensable “Bailout Nation,” it’s disappointing to see Rithotlz propose the solution he does.  Instead of finally getting rid of the absurd notion of “too big to fail,” he favors maintaining one of the bureaucracies most at fault for incentivizing excessive risk in the financial sector.  He misses the root of the problem while advocating the continuation of keeping taxpayer money at risk to cover the failed investment decisions of others. Tinkering around with FDIC rules doesn’t fix what over a century of government enabled fractional reserve banking created.

Empirically, Rithotlz is correct that a lower threshold of coverage for deposit insurance may actually promote stability in the banking sector.  As economist Kam Hon Chu points out in a recent Cato Journal article:

Therefore, the assertion that higher deposit insurance coverage can induce a more stable banking system might still be empirically valid. Yet a further examination of the data indicates that the opposite is actually the case in reality. Deposit insurance schemes with low coverage actually had fewer banking crises in terms of both absolute number and proportion — only one systemic crisis among 22 countries. This country is South Korea, which suffered a systemic crisis during 1997–2002 as a result of the Asian currency crisis. In contrast, schemes with high coverage had the highest numbers of banking crises: three non-systemic and six systemic. In terms of proportion, the seven schemes with full coverage had the worst performance. Three or nearly half of them registered systemic banking crises.”

Empirical evidence doesn’t always prove causation in the science of economics however.  Since man is free to choose, isolated cases don’t translate into what would happen in every future instance.  Trends can be observed and interpreted by understanding that man acts purposefully and will react to incentives.  Since markets have internalized checks which enable them to regulate and encourage those firms or entrepreneurs which satisfy consumers the most, banks operating in open competition would be forced to rely on an established record of business to attract patrons.  Rithotlz actually recognizes this in the closing to the letter:

As a bonus, without the intervention of government guarantees, those of you who continue to have depositors will finally be able to compete in a free and open market. Without FDIC insurance, your depositors will be making their decisions based on your reputation, and their assessment of the safety and security of your operations — and not Uncle Sam’s willingness to continually bail you out.

What he fails to do is take the implications of dynamic, unfettered competition and apply it wholly to the banking sector.  If McDonald’s and Burger King must produce tasty fast-food to draw consumers away from each other, banks also have to operate under the same conditions in that they have to convince potential customers that their money is safe within their proverbial vaults.  Not only does this competition limit the amount of un-backed credit expansion which threatens the solvency of banks, it serves as a disincentive to not engage in highly leveraged investing for fear of losing depositors who perceive their money to be at greater risk.

These market-produced checks and balances don’t exist anymore within the context of today’s central banking system and government guarantees of deposits.  What has happened is that bankers have been assured that their reckless speculations are protected to a certain degree.  High risk, high profit investments now appear more attractive when the potential downside is cushioned by the pledge of stolen income.  The Federal Reserve exacerbates this immoral state of affairs with its monopoly over the printing press.

And as Frank Shostak aptly recognizes,

By means of monetary policy, which is also termed the reserve management of the banking system, the central bank permits the existence of fractional-reserve banking and thus the creation of money out of thin air.

The modern banking system can be seen as one huge monopoly bank that is guided and coordinated by the central bank. Banks in this framework can be regarded as “branches” of the central bank.

The existences of the Federal Reserve in itself means that all banks are functionally under the tutelage of government-enforced regulation.  It has been this way since 1913.  The purpose of the Fed was always to serve as a backstop for credit creation out of thin air.  Its formation had no angelic intent behind it.  Scheming bankers and their political enablers sought out a “lender of last resort” to cartelize the industry against competitors and also to ensure a steady flow of income directed toward government bonds.  The banks got their implicit bailout guarantee.  The federal government got its backdoor printing press.  The general population was gifted with being forced to use dollars that have lost 97% of their purchasing power since the Fed opened its doors.

The FDIC’s deposit insurance will always serve as another incentive for banks to expand credit and take riskier positions.  The solution isn’t for the bureaucrats in charge to come up with new operating rules and “be more conservative in our risk management and assumptions,” it is to finally do away with the implied socialization of losses.  The fact that taxpayer funds were put at risk to aid the speculative errors of a politically favored industry is demonstrative of the insidious nature of state intrusion into the market.  Forced deposit insurance is of little benefit of the taxpayer.  It gives the public a mirage of security when it is of full benefit to the banking class that maintains better access to pools of capital from which to pyramid credit creation.  When it all comes crashing down as boom inevitably turns to bust, as it did in the financial crisis, taxpayers are thrown under the bus in favor of Wall Street.

In short, government deposit insurance, like central banking, is a racket.  The state specializes in fooling the masses into believing themselves protected from all the great insecurities of life.  The reality is that they are viewed as empty vessels from which to siphon off as much wealth and resources as possible to enrich public officials and their benefactors.

It’s a shame Rithotlz, for all his valuable insights, still buys into the fable of “good government.”