Europe strikes deal to push cost of bank failure on investors

[Ghost of Cutten]

Quote from Martinghoul:

Well, it may be efficient to backstop "some" deposits in the interest of having a banking system that is not completely reliant on the state during times of stress. However, it's also very true that too much of a good thing can breed moral hazard and introduce other unpleasant issues. So in this case, like with most other things in life, it's important to find the right balance.

Furthermore, you could, sorta, argue that you could, in theory, make the deposit insurance levy a tax on the banking industry, rather than the taxpayer. If the banking industry in the US weren't so concentrated and not particularly competitive, that might actually be the case.

Generally, I can point you to a couple of really good papers that discuss these issues and that can make the case a lot more eloquently.

Wait - why is efficiency important? I didn't offer to pay for someone else's idea of efficiency. Why is the state allowing the banking system to rely on it during times of stress? You are just skirting around the issue I raised - why should banks get a special subsidy in times of stress, one that is denied to ball-bearing manufacturers or panel-beaters for example? Or even hedge funds - if they go bust, they don't get a bail out.

The only reason I can think of is that the societal disruption is so large that it become politically untenable. But if that is likely to be the case (clearly true in the current system), then the system needs to be changed so that is not the case...NOT tweaked so other people fund it (under forcible coercion i.e. tax payments) to make it a bit less bad.

Remember that the deposit insurance limits will not be 'hard' limits, but are subject to whimsical change up, down, or to infinity (e.g. Ireland) based on the backroom dealings and poll numbers of a small number of not-disinterested bankers and politicians, along with the baying lynch mob of the pissed-off public. The fact is, that system is so unstable in crises that all bets are off once one arises. No one will be interested in an academic paper when the shit is hitting the fan, they will be scared and interested in political survival, avoiding loss of life savings, business bankruptcy etc.

For example, what if this EU proposal had existed worldwide in 2005? Are we to believe that in the heat of the 2008 panic, the rules would have been followed? Or would some numbers have been plucked out of someone's arse?

The problem is not that the banking system periodically goes bust. The problem is people expecting it not to, when it clearly runs a predictable risk of doing so due to its highly leveraged nature, and its tendency to get exposure to speculative manias.

What about a shift to a system that would avoid, or seriously reduce this risk, without requiring an arbitrary hidden taxpayer subsidy? For example: a government owned or backstopped bank (or class of banks) which invests purely in t-bills, and charges a fee for handling normal day to day banking operations. All other banks are pure caveat emptor for everyone including depositors. If a private scheme wants to insure them, go ahead - but no tax-funded insurance.

Or, only offer deposit insurance to full-reserve banks. Clearly explain the difference. Then, anyone who chases yield by investing in the fractional reserve sector, has no grounds to moan when it blows up again.

 

[Martinghoul]

Quote from Ghost of Cutten:
The reason insurance companies are not bailed out (much) and banks are, is simple - when banks get wiped out people lose their life savings, then vote in a different government (and bring forward elections/regime change by street protests etc). When insurance companies fail, the loss is far less, because insurance premiums are typically a small fraction of the sum insured. Policies can quickly be transferred to another provider, and in the worst case the insurance customer simply loses the annual premium, a relatively small sum.

Remember the Albania pyramid scheme collapses in the 1990s? That toppled the government. Nothing to do with banks, pure scam and stupidity. The public generally think that the government has a responsibility to stop mass wipeout of private savings - even if it was entirely the public's stupidity that caused their own losses. That applies whether it is dishwashers and taxi drivers losing their life savings to pyramid schemes, or the middle class losing their deposits to banking collapses, or the upper class elite losing their capital in a market crash. There will be special pleading in each case. And the fact is, 99.9% of people lack the specialist knowledge and experience to understand and anticipate financial collapses - they trust the professionals to do that for them. When this doesn't happen, they expect the government to step in and make things right.

AIG was not bailed out because it had 'become a bank' (it hadn't - where was the large base of depositors?). It was bailed out because of the political connections of its main customers, and paranoia about market repercussions from its trading desk - so similar reasons to LTCM, which was rightly rejected. AIG was bailed out because 2008 was more scary than 1998 and government lost their nerve after seeing the post-Lehman carnage. If it had been left to hang, the market would have been volatile for a bit and then would return to normal.

The reason banks are more leveraged is simple - their culture is more aggressive relative to insurance companies. Banks pay more and so they attract higher IQ, more ambitious, more socially adept, and less ethical/more money-focused people. Insurance companies tend to attract more conservative, less ambitious, more steady eddie types. Banks are usually located in the biggest/most money-driven metropolitan centre in a country; insurance companies are often in mid-size provincial cities. So insurance companies by nature are more risk averse and less go-getting. Why this is the case, I'm not 100% sure, but it seems a durable rule of thumb.

P.S. Buffett's 20 year put sale was one of the worst trades of all time - he sold them at historically low vol right before the worst market crash since the Great Depression.

P.P.S. the market price is sometimes hopelessly wrong at forecasting the future e.g. speculative manias. There is no such thing as the 'right' price for an asset because people have purely subjective risk preferences and discount rates. However, it is undeniable that human psychology causes predictably impermanent gross distortions of pricing, that revert back to the normal every single time. There has never been a bubble in financial history that has not eventually burst.

I am not sure I completely agree with your point about why the insco's don't get bailed out. Don't think it's a matter of premia, really. I mean, sure, a loss of a life insurance policy feels like it's less of an immediate pain than losing a bank deposit, but it can still be a large loss.

At any rate, the point I was making wasn't regarding that. It was more about why, regardless of bailouts, insco's exhibit a lower failure rate than financial institutions. And my response is that it's not because banks face more "black swans" (I hate this term, btw), but rather that they are more leveraged and thus more fragile. As to why banks are that way, it could be a whole bunch of things. For instance, it could be the result of the moral hazard that's been cultivated since Glass-Steagall has been repealed.

And yes, my point about AIG was precisely along the lines of what you mention, regardless of deposits. The issue with AIG was that it effectively became much more of a financial institution than a traditional insurer in terms of the size of its presence in the mkt and its interconnectedness. Moreover, the other, particularly egregious thing with AIG was the incredible amount of leverage that they could get away with because of the AAA rating. But, obviously, as they discovered, a rating arb is a double-edged sword.

P.S. I am inclined to disagree with you re Buffett's put trade. Given the various "fringe benefits", I think it's a fantastic trade for someone with very deep pockets, regardless of vol. When I think of it as a simple funding trade, it's pretty nifty.

P. P. S. Yep, although, obviously, defining what is and what isn't a bubble is a thankless and very subjective task.

 

[Ghost of Cutten]

Quote from Martinghoul:

I have said this many times. Full reserve banking doesn't work and doesn't exist other than a purely theoretical concept. It certainly won't be viable in an environment where full reserve banks are expected to compete against the fractional reserve ones. UK building societies are emphatically NOT full reserve banks. They do confine themselves to specific activities (take in deposits, lend mortgages), but they're all pretty nicely leveraged.

Yes, agreed 100% there. As I have said a number of times, there's a perception that banking is another "public good", like sanitation or public order. If that is indeed the case, I find it utterly ridiculous that it's not regulated and controlled by the state in a way that's consistent with the assumption.

Well, sovereign debt and bank deposits are different animals. Greek insured depositors didn't have to suffer a haircut, I am pretty sure. Argentina is a different story, indeed, but that country is special in some many ways.

Isn't National Savings and Investments in the UK a full reserve bank? And a large t-bills fund that offered money transactions services would be able to be a bank also.

Also, why wouldn't a full reserve bank be able to compete? That sounds like saying a t-bills fund can't compete with an equities fund or a 10 year bond fund. If people want absolute safety, a full reserve bank is the closest way to provide that. People invest in t-bill funds, so there is clearly a desire for super-safe places to put money.

Also, if a fractional-reserve system is free-riding on society via implicit bailout, one can simply tax it at an appropriate level - which would be the level at which full-reserve banks CAN compete. Or if super-safe banking is perceived as a public good, then provide it from the state as a public service, like nationalised healthcare, defence, courts, public order via police etc.

About Greece, I was simply using it as an example of a sovereign defaulting, to back up the main point that the banking system can only be bailed out by the state if the state is actually solvent.

 

[Humpy]

Quote from Ghost of Cutten:

What about the gross incompetence of the people in society who either voted for these politicians, or didn't do anything about if beforehand, or didn't apply sufficient political pressure for action afterwards, or never got involved in the political process themselves. Where were the slew of reformist candidates, and who voted for them?

It's easy to blame others, harder to actually do something about it yourself.

Also, just punishing one section of society will just mean that less able people get into it next time. Imagine being an honest banker for the last 30 years, and your clients didn't get hosed in 2008 - now even 5 years later your name is still mud just because a minority in your profession acted incompetently or unethically. Imagine an honest person thinking of entering politics - must be rather offputting to know you will be hated just for your job even if you succeed and do nothing wrong. Then the people doing the hating will turn around and moan about the low standard of bankers and politicians. Well duh.

The Public - a group of people who will shoot themselves in the foot then complain about the gun maker and their marksmanship instructor.

There should be a deterrent to the younger generation imho. Those amateurs in politics know that it doesn't really matter if they make a complete balls-up. They get a big payday and a gold plated pension whatever the outcome. Letting crooks like Nixon off the hook just encourages the wrong sort of attitude. Incompetents like Bush jnr and that peanut farmer should have faced charges imho. If they want the job and make pledges etc to get elected they should deliver.
The general public believed their spiel and voted them in. How were they to know better ?
It just goes to show how useless democracy is. The public goes with the promise of big handouts etc. That's no way to run a country. More suited to a 3rd rate banana republic.

The US should take a look at their competitors. It is no magic formula that they are catching up the 18th century system. Greed etc is NOT good regardless of Wall St. clever dicks.

 

[Martinghoul]

Quote from Ghost of Cutten:
Wait - why is efficiency important? I didn't offer to pay for someone else's idea of efficiency. Why is the state allowing the banking system to rely on it during times of stress? You are just skirting around the issue I raised - why should banks get a special subsidy in times of stress, one that is denied to ball-bearing manufacturers or panel-beaters for example? Or even hedge funds - if they go bust, they don't get a bail out.

Well, the best reason that I can think of is that it seems that this is the best thing to do, based on available empirical evidence. This is further theoretically corroborated if you perceive (as most societies do) banking as a public good. After all, the government doesn't allow water and sewage or police and fire services to lapse during times of distress, for example.

The only reason I can think of is that the societal disruption is so large that it become politically untenable. But if that is likely to be the case (clearly true in the current system), then the system needs to be changed so that is not the case...NOT tweaked so other people fund it (under forcible coercion i.e. tax payments) to make it a bit less bad.

Well, that's the thing, I kinda agree... But, like I mentioned above, bank runs have been studied pretty exhaustively. There's a LOT of thought that has gone into the various possible ways to address them. Among the people who have contributed to this discussion are people I have some respect for, such as Walter Bagehot and Milton Friedman. And the conclusion is that there doesn't seem to be a "good" way of doing this, other than some combination of deposit and liquidity insurance. Obviously, this is not to say that no other solution will ever be found and, clearly, the modern banking systems present new challenges. Yet again, I would refer you to an excellent "Banking on the State" paper by Haldane & Alessandri, which talks about these issues.

Remember that the deposit insurance limits will not be 'hard' limits, but are subject to whimsical change up, down, or to infinity (e.g. Ireland) based on the backroom dealings and poll numbers of a small number of not-disinterested bankers and politicians, along with the baying lynch mob of the pissed-off public. The fact is, that system is so unstable in crises that all bets are off once one arises. No one will be interested in an academic paper when the shit is hitting the fan, they will be scared and interested in political survival, avoiding loss of life savings, business bankruptcy etc.

For example, what if this EU proposal had existed worldwide in 2005? Are we to believe that in the heat of the 2008 panic, the rules would have been followed? Or would some numbers have been plucked out of someone's arse?

Yes, agreed, but that's democracy for ya, innit?

The problem is not that the banking system periodically goes bust. The problem is people expecting it not to, when it clearly runs a predictable risk of doing so due to its highly leveraged nature, and its tendency to get exposure to speculative manias.

What about a shift to a system that would avoid, or seriously reduce this risk, without requiring an arbitrary hidden taxpayer subsidy? For example: a government owned or backstopped bank (or class of banks) which invests purely in t-bills, and charges a fee for handling normal day to day banking operations. All other banks are pure caveat emptor for everyone including depositors. If a private scheme wants to insure them, go ahead - but no tax-funded insurance.

Yep, I would have no problem whatsoever with such an arrangement. Obviously, if you're a libertarian, relying on the government to manage yet another aspect of society would be anathema to you, but I think I can handle it.

Or, only offer deposit insurance to full-reserve banks. Clearly explain the difference. Then, anyone who chases yield by investing in the fractional reserve sector, has no grounds to moan when it blows up again.

Again, I am not sure you could have two of these co-existing within a single marketplace.

 

[Martinghoul]

Quote from Ghost of Cutten:
Isn't National Savings and Investments in the UK a full reserve bank? And a large t-bills fund that offered money transactions services would be able to be a bank also.

NSI is HMT or, in their own words, an Executive Agency of the Chancellor of the Exchequer (just a way to issue gilts to retail investors). And, I assure you, HMT isn't a full-reserve entity by any description.

Also, why wouldn't a full reserve bank be able to compete? That sounds like saying a t-bills fund can't compete with an equities fund or a 10 year bond fund. If people want absolute safety, a full reserve bank is the closest way to provide that. People invest in t-bill funds, so there is clearly a desire for super-safe places to put money.

Well, again, like I said before, there's a whole weight of historical precedent suggesting this.

Also, if a fractional-reserve system is free-riding on society via implicit bailout, one can simply tax it at an appropriate level - which would be the level at which full-reserve banks CAN compete. Or if super-safe banking is perceived as a public good, then provide it from the state as a public service, like nationalised healthcare, defence, courts, public order via police etc.

YES and YES!

About Greece, I was simply using it as an example of a sovereign defaulting, to back up the main point that the banking system can only be bailed out by the state if the state is actually solvent.

Yep, with you now.

Quote from Ghost of Cutten:
Leverage. When was the last time a full reserve bank went broke?

Yes, exactly the point I was trying to make.

 

[Butterball]

Quote from Ghost of Cutten:

Welcome to politics, kiddo!

You wouldn't call me kiddo if you stood in front of me, armchair warrior.

 

[piezoe]

n.b. FDIC insurance premiums ("assessments") are paid by the depository institutions themselves. Rates paid vary by formula according to risk category and other factors. For a well capitalized bank in the lowest risk category the current assessment rate is about 12-16 b.p. and can range much higher depending on risk category. The rates now are notably higher than the pre-2008 rates. There was a period prior to 2008 when some well capitalized banks in the lowest risk category paid a zero assessment rate! Obviously risk assessment is subject to error.

 

[StarDust9182]

Quote from Ghost of Cutten:

There is not even any such thing as 'properly priced' on a value basis, even if the future is perfectly knowable, because people have different time value of money, different utility functions etc. Add in the unpredictability of the future as well, and it is hopeless. So, there is no such thing as a stable 'anchor' value in the markets. The only proper price is the one right now based on pure supply and demand, and clearly the limits of how far supply and demand can push things are quite extreme (and certainly way beyond 'fair value' for normal times and expectations).

However, why does that matter? You seem to be assuming that it is necessary to be able to estimate the 'proper price' (whatever that is) in order to trade something. But it is not necessary at all to know the proper price of something. You can trade it either on a pure supply & demand basis, or simply trade only when the odds of it being substantially undervalued or overvalued are enormous, and where the chance of being squeezed out are minimal. No knowledge of the 'proper price' is needed.

The closes thing to actual investing is fully paid purchases made unleveraged, with no regard to the ongoing secondary market price or liquidity, where the return is coming purely from the internal returns (dividends, spinoff/distribution payouts, takeovers etc) of the business. Everything other than that is to some extent a pure gamble on price fluctuations, which are only very loosely tied to underlying 'value'. And that value itself is subject to very wide fluctuations based on the unpredictability of the future - business cycles, obsolescence, mismanagement, fickle consumer sentiment, political conditions etc. Investors simply gamble on business, consumer, worker, and political conditions; whereas speculators gamble on investor sentiment about those conditions (i.e. a 'derivative' gamble a la Keynes' beauty contest).

Why does the real price matter? Because whenever money is lent or invested, there are two sides to it. One is the investing side (return) and the other is the repayment side (the risk). In a perfect world the risk and return would fall on the same entity. That is, the person getting the return would have to account for the default ratio or go out of business. Insurance is closer to that model, in that insurance companies not covering their a**** (AKA risk will cease to exist). So a full reserve banking system would not fail longer term IMO.

But through the magic of fractional reserve and derivatives, suddenly the rewards are taken by some individuals, and the risks are borne by others. (similar to politics [I like the definition by Robin Williams? - poly means many, tics are blood sucking insects and thus politics are many bloodsucking insects]). So there is ultimately no check on excessive risk-taking in our current banking system. That is the source of the systemic risk.

If the true cost (aka risk value) can't be determined longer term, then failure is certain eventually in a world of high sigma events. That is the underwriting default risk of the loan.

 

[StarDust9182]

Quote from Ghost of Cutten:

.....

What about a shift to a system that would avoid, or seriously reduce this risk, without requiring an arbitrary hidden taxpayer subsidy? For example: a government owned or backstopped bank (or class of banks) which invests purely in t-bills, and charges a fee for handling normal day to day banking operations. All other banks are pure caveat emptor for everyone including depositors. If a private scheme wants to insure them, go ahead - but no tax-funded insurance.

.......

Absolutely right. See the Chicago plan from 1933. Instead we got the FED plan - pump up the world, refinance everything until the problems go away. That battle lost was the beginning of the end IMO.