Insuring Deposits, Ensuring Insolvency

On July 24, 2013, in Opinion, by Republished Articles | Jump to Comments | Leave a Response

by Frank Hollenbeck

The US government is trying to implement the 21st century version of the Glass-Steagall Act of 1933. The proposed bill would separate traditional banks (which are backed by the FDIC) from riskier financial institutions that include companies focused on investment banking, private equity and more. This is to give the impression that governments are taking actions against the financial sector whose actions nearly brought the entire world economy to its knees back in 2008. The implicit assumption is: if this legislation is passed, the banking sector will never again be a source of financial panics. Nothing could be further from the truth.

First, the housing bubble would still have existed without investment banking. The liar loans and no-money-down loans were all commercial banking activities. If these mortgage loans had never existed, investment banks could not have repackaged and sold then to mutual and pension funds, and insurance companies. By setting rates too low for too long, the central bank created an environment for bubbles. Glass-Steagall would have been a bump in the road. If a child goes into a candy store and “pigs out”, do you blame the child (the bankers), or the parents (the central bank) for putting him in the candy store in the first place?

Second, the US experienced several severe financial crises during the 19th century: the panics of 1819, 1837, 1857, 1873, 1893 among others. At the time, most investment banking activities did not even exist. The banking sector’s ability to create money out of thin air allowed the excessive credit growth, unjustified by the resources liberated by real savings, which spurred economic activity during the boom phase of the business cycle. This growth could not have occurred without fractional reserve banking. End that, and you end most boom and bust cycles.

The Glass-Steagall act was completely repealed in 1999 with the Gramm-Leach-Bliley act, allowing commercial banks to easily enter investment banking activities. In other words, fractional reserve banking and deposit insurance allowed banks to take on risky gambles, and now they were being allowed to engage in even riskier gambles. The recent legislation such as Dodd-Frank, the Vickers report in the UK and the liikanen report in Continental Europe all try to limit commercial bank activity into investment banking. The essential idea behind some of these new rules is each gamble would be assigned a risk weighting. A commercial bank could then only take on so many bets before being required to split off these risky activities into a separate entity.

No one, of course, is asking the critical question: why are banks allowed to take these risky gambles with deposits in the first place? They shouldn’t be.

Deposit insurance is one of the two factors which allows banks to take such risky gambles. Created in 1933, it is a perfect example of government policy that ultimately will be determined to have done more harm than good. It was supposed to reduce risks, but has done just the opposite. When governments provide flood insurance the private sector would never consider, people then build homes in areas prone to suffer from severe flooding.

Prior to deposit insurance, people were careful about where they deposited their money to pay rent or food bills. If a bank ran into trouble by undertaking poor lending practices, people would quickly try to pull their money out of the bank. Bank runs were a good thing because runs served to force banks to be extremely careful about their lending practices. The threat of a bank run maintained sound incentives.

Deposit insurance is a perfect example of Frederick Bastiat’s parable of the broken window: what is seen, and what is not seen. For about 70 years, bank runs have been eliminated; giving depositors what some would say is the illusion of protection. That is what is seen. What is not seen is, without insurance, banks would have been taking much less risks with deposits, and governments would have been less able to finance spending through bank purchases of their bonds.

Europe, today, is a perfect example of the disastrous effects of deposit insurance. Had it not existed, the 2008 crisis might have never occurred, or been much milder or occurred much earlier, and the debt situation of governments worldwide would be completely different. It is surprising how many free market economists defend deposit insurance although it is a product that the free market, prior to 1933, never considered worth undertaking.

Why was Ireland forced to bail out its banks? Why don’t governments treat banks like any other business? If Nokia was unable to sell phones competitively, it should go bankrupt. The government should not be bailing out private businesses. Again, it is the fault of deposit insurance. Although a bank may no longer exist, the government is still liable for the banks’ liabilities, its deposits, because of deposit insurance.

Today, many Italian or Spanish banks have used deposits to buy large percentages of their government’s debt. If either Spain or Italy is closed out of the financial markets, which is getting more and more likely, the value of their debt will drop significantly as Greek debt did back in 2010. These banks will go bankrupt instantly, and the Italian or Spanish governments will be on the hook for the deposits that served as funds to purchase their bonds since these deposits are insured!

These governments will then have to print their way out of the problem. However, this would go against the ECB’s mandate and would probably face a German veto. A breakup of the Euro would then be inevitable. An official rate would then be set between Euros and liras or pesetas. This rate, however, would have nothing to do with the market rate. Depositors holding less than 100,000 euros would get their money back in liras or pesetas. However, this new currency would not be able to buy much. Deposit insurance guarantees the nominal value of deposits, not its real value: hence, the illusion of protection.

The economic consequences of the hyperinflation inevitable in Spain or Italy will have worldwide repercussion. None of this would have happened without fractional reserve banking. Deposit insurance would then have been unnecessary.

We need to end this constant race between banks and regulators. We already have more compliance officers than loan officers. All this new banking legislation will probably make the situation even worse. Banks will always be able to use new technologies and new financial instruments to stay one step ahead of the regulators. We continue to put bandages on a system that is rotten to the core. Banking in its current form is not capitalism. It is fraud and crony capitalism, kept afloat by ever-more desperate government interventions. It should be dismantled.

Republished via

Tagged with:

Related Articles

2 Responses to Insuring Deposits, Ensuring Insolvency

  1. Frank Hollenbeck says:

    Thanks for your comment. I had not read the WSJ article.

    I am afraid your comment will lead to the wrong conclusions and create another period of illusion of safety. The ECB followed a similar easy monetary policy and led to a housing bubble in Spain three times the size of that in the USA. Investment banking activity had almost nothing to do with that. It was all commercial banking activity. Had Glass Steagall been in place between 2001-2007,speculation on free money would simply have found another avenue and the crash may have been later and more severe. However, your comment insinuates that we can fix the system. We can’t. We have to rebuilt it from the ground up, and that can only be done by implementing something like the Chicago plan. (100% reserve banking)

  2. Bill Roberts says:

    The 2008 crisis wasn’t a mortgage crisis. Exotic mortgages had become the inflated assets around which a derivatives bubble was built up. But what allowed for the huge quantity of loans to investment firms like Lehman Brothers to buy up all the mortgage backed securities that kept the sub-prime mortgage market expanding? “Commercial” banks like J.P. Morgan whose commercial activities were FDIC insured, made huge loans to firms like Lehman brothers to purchase these securities, an activity that wouldn’t have been allowed under Glass Steagall.

    Also, with the repeal of Glass Steagall, the “distinction” between commercial and investment banks was blurred as investment banks used short term “deposit-like” assets to fund long term investments. It was this across-banking-distinction-lines type activity which set up the TBTF problem.

    Your argument seems like another version of the “Glass Steagall wouldn’t have affected the crisis” argument that we have all heard from liars like Barney Frank.

    Here is an excerpt from a WSJ article by FDIC vice president Thomas Hoenig where he destroys this argument that Glass Steagall repeal had nothing to do with the banking crisis:

    “This assertion ignores that the largest bank holding companies and broker-dealers were engaged in high-risk activities supported by explicit and implied government guarantees. Access to insured deposits or money-market funds and repos fueled the activities of both groups, making them susceptible to the freezing of markets and asset-price declines.

    Before 1999, U.S. banking law kept banks, which are protected by a public safety net (e.g., deposit insurance), separate from broker-dealer activities, including trading and market making. However, in 1999 the law changed to permit bank holding companies to expand their activities to trading and other business lines. Similarly, broker-dealers like Bear Stearns, Lehman Brothers, Goldman Sachs and other “shadow banks” were able to use money-market funds and repos to assume a role similar to that of banks, funding long-term asset purchases with the equivalent of very short-term deposits. All were able to expand the size and complexity of their balance sheets.

    While these changes took place, it also became evident that large, complex institutions were considered too important to the economy to be allowed to fail. A safety net was extended beyond commercial banks to bank holding companies and broker-dealers. In the end, nobody—not managements, the market or regulators—could adequately assess and control the risks of these firms. When they foundered, banking organizations and broker-dealers inflicted enormous damage on the economy, and both received government bailouts.”

    Read the full WSJ article here:

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>

Looking for something?

Use the form below to search the site:

Still not finding what you're looking for? Drop a comment on a post or contact us so we can
take care of it!

Visit our friends!

A few highly recommended friends...