Friday, 27 June 2014

A flaw in FDIC type bank insurance.

The Federal Deposit Insurance Corporation is a government run, self-funding insurance system for small banks in the US.
Most of us want a banking system that offers depositors total security, even when a bank goes bust. FDIC is one method of achieving that, and another is full reserve banking. Or to be more accurate, what full reserve offers depositors is two types of account. One offers total security, but that is achieved by doing nothing the faintest bit risky with the money involved (the money is simply lodged at the central bank and/ or invested in short term government debt). And the second type of account involves lending on money in a more risky manner (e.g. to mortgagors and businesses). But in that case, depositors carry the full cost when those loans fail. In effect, those depositors are bank shareholders.

So which is better: FDIC or full reserve?
Like full reserve, FDIC involves depositors in paying pretty much the full costs of what they engage in, or put another way it involves depositors carrying the cost of any losses made by their bank: they just pay via an insurance premium.  
It can well be argued that under both systems, part of the cost is passed on to borrowers. But let’s assume to keep things simple that the PROPORTION of costs passed on the borrowers is the same in both cases (full reserve and FDIC).

Bank failure under FDIC.
Under FDIC, when a bank’s assets fall to some proportion of it’s liabilities (90%, 80%, or whatever), the bank is closed down, FDIC grabs and sells off the assets and reimburses depositors from both the proceeds of sale of those assets plus the fund of money that FDIC has built up as a result of charging insurance premiums.
As to bank shareholders, they of course take a hair cut: maybe a 100% haircut – that is, they’re wiped out.
Under full reserve, there’s no need for FDIC because a bank or lending entity funded just by shareholders cannot suddenly go bust (though it can decline due to bad management over a period of time). Or as George Selgin put it in his book “The Theory of Free Banking”, “For a balance sheet without debt liabilities, insolvency is ruled out”.  

The apparent advantage of FDIC.
So what’s the advantage of the conventional or existing system under which banks are funded predominantly by depositors or similar types of short term creditors, with shareholders providing only a small proportion of the bank’s funds and with FDIC acting as backstop?
Well the advantage seems to be that commercial banks can create a form of money: undoubtedly a useful service. That is, banks SPECIFICALLY make that asset/liability liquid so as to turn it into a form of money. Plus the VALUE of each unit of those liabilities is fixed in value (inflation apart). That is, you can guarantee that a dollar or pound Sterling (unlike shares) won’t drop in value by more than about 0.01% in the next 48 hours.
And that “more or less fixed in value” characteristic is near essential if the relevant liability is to be classified as money. Reason is that one of the essential ingredients of money, as per text book definition of the word, is that money is a “measure of value”. And just as you cannot measure the length of something with an elastic tape measure, you cannot measure the value of anything with a form of money whose OWN VALUE keeps changing.
An obvious exception to the latter point comes with Bitcoin, which DOES CHANGE in value. But Bitcoin will never become a serious competitor for state issued money until it becomes fixed in value.
So to summarise so far, the big advantage of commercial banks backed by FDIC seems to be that they can issue a form of money.

Central banks also issue money!
But CENTRAL BANKS can just as easily create or supply the economy with a form of money and at practically no real cost. Indeed they already do produce a portion of the money supply. So the latter apparent merit in letting commercial banks have traditional depositors backed by FDIC collapses!
Put another way, what’s the point in a system that CLOSES DOWN banks when they make silly loans, if there is a system available (i.e. full reserve) under which banks DO NOT have to close down when they make silly loans? There IS NO point!

A flaw in Positive Money’s system.
Strangely enough, while PM advocates full reserve, the PARTICULAR FORM of full reserve advocated by PM actually retains the latter “close down” defect. That is, their system is not a PURE full reserve system, and for the following reasons.
Under PM’s system, there is no FDIC, and depositors who opt to have their money loaned on (i.e. put at risk) are guaranteed £X back for every £X they deposit until such time as the bank has clearly failed. And at that point, depositors may have to accept a hair cut.
In contrast, under Laurence Kotlikoff’s full reserve system, those who want their money loaned on or put at risk buy into a mutual fund (unit trust in the UK) of their choice. That way, it’s near impossible for lending entities (i.e. mutual funds) to go bust. And for that reason, I prefer Kotlikoff’s system.
Indeed, another strange characteristic of the PM system is thus. Say a bank’s assets fall to the point where it is closed down, which is where its assets have fallen to say Y% of its liabilities. That means that depositors will get Y% of their money back, roughly speaking. But in the same scenario under the Kotlikoff system, those depositor / investors would see their stake in the bank / mutual fund drop to Y% of its initial value. So under both systems, depositors end up with Y% of their original stake, but under the PM the bank is closed down, whereas under Kotlikoff's system it soldiers on.
Ergo . . . the PM system, you could argue, involves closing down banks for absolutely no reason.

Taxpayer funded bank insurance.
In contrast to FDIC, which as pointed out above is self-funding, an obvious alternative is to have taxpayers stand behind banks or “fund bank insurance” if you like. The latter system applies to large banks in the US (the so called “Too Big to Fail” subsidy), and all banks in the UK. Or to be more accurate, there’s a sort of TBTF subsidy in the US, but it seems the US government is prepared to let the occasional large bank fail (i.e Lehmans) pour encourager les autres.
However, TBTF is clearly even worse than FDIC, and indeed the declared objective of those trying to bring better bank regulation, like the Vickers commission in the UK, is to dispose of all bank subsidies, an objective they’ve completely failed to achieve .
Indeed, the worthies trying to dispose of bank subsidies don’t seem to have the faintest idea as to how to do it.

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