The Banks that Ate the Economy

Goldman is right that small banks fail and have been protected by government insurance and bailouts but that means that the big banks funding advantage over small banks needs to be added to whatever advantage the small banks themselves have.

Consider what happens when banks in Texas, Florida, or California make bad lending decisions that threaten their survival.

There is little chance that banks will re lend to these non banks the funds they borrowed from central banks, given these banks own severe liquidity problems and mistrust of non bank counterparties.

It might have been hoped that the bank supervisors who stress tested the banks would try to estimate the size of the banks losses on toxic assets.

But the contrast between bank profitability and the woes of everyone else turns up the political heat on the central banks, which have to explain why it is only their friends, the banks, who are standing under the helicopter when it drops money.

But, unlike banks, they do not have the safety net implied by central banks role as lender of last resort.

In the case of the banks that required state rescues, European competition rules are requiring divestment and downsizing.

State controlled banks allocate capital.

But how much public capital should be used, and on what terms? Private capital, of course, is preferable, but, given the risk that it will be wiped out by future public intervention, investors will be wary.

Recapitalization has not yet reached the point where there are enough strong banks.

Recapitalization of banks that appeared very vulnerable

But it paid a price for this bank funded investment boom.

Numerous medium sized banks, and some large ones, are set to go under in the stock market turmoil.

Because securitization meant that banks were not carrying the risk and earned fees for transactions, they no longer cared about the quality of their lending.

European and other international banks had acquired a lot of dollar denominated assets which they habitually funded in the interbank market as the market dried up, they were forced to buy dollars.

Recognizing this problem, banks can hold their host governments to ransom.

Improved central bank policy is another huge factor.

Current low interest rates do not cover the risk that banks would take.

Banks still don t trust each other, since each wonders how many skeletons the other has in its closet.

Central banks statutes differ in terms of the objectives that they set for monetary policy.

This episode serves as a reminder that central banks are political institutions, with a political agenda, and that independent central banks tend to be captured (at least cognitively ) by the banks that they are supposed to regulate.

Because government provides deposit insurance, it plays a large role in restructuring (unlike other sectors). Normally, when a bank fails, the government engineers a financial restructuring if it has to put in money, it, of course, gains a stake in the future.

The hiccups in Western banks have served to disrupt the availability of trade credits, and, if amplified, could destabilize local banks.

Bank shares in particular are rebounding, and some banks have even succeeded in repaying at least part of their government provided capital.

How to Bail out Good Banks and Let Bad Banks Fail

There are many ways of curbing big banks excesses.

The dollar, they observe, is the funding currency for banks around the world.

And that appears to reflect the banks political power.

A full scale financial crisis is triggered by a sharp fall in the prices of a large set of assets that banks and other financial institutions own, or that make up their borrowers financial reserves.

The choice to save the banks from the financial consequences of their own errors indicates a shift in values away from belief in the wisdom of the market.

Time and again, banks woes have affected governments borrowing costs, and concerns over governments solvency have affected banks balance sheets.

In Europe, the banks wounds must be closed weak banks must be shut down or merged with stronger banks before recovery can begin.

Afterwards, the liquidated, formerly over indebted banks could be sold.

Where banks did increase their lending, it was the result of political pressure.

The political power of global megabanks is out of control.

The commercial banks main losses were incurred in the residential and commercial housing market.

Similarly, European and American banks keep the resources that are looted from Africa.

The only thing we got wrong was how bad banks lending practices were, how non transparent banks really were, and how inadequate their risk management systems were.

Indeed, the Asian Development Bank estimates that European banks fund about 9 of total domestic credit in developing Asia three times the share of financing provided by banks based in the United States.

But that decision, and bad policies by central banks and governments since then, has given over indebted major banks the power to blackmail their rescuers a power that they have used to create a financial system in which they are effectively exempt from liability.

Indeed, more often than not, the banks that failed or had to be rescued in the wake of the 2008 financial crisis had solvency ratios higher than those of banks that remained standing without assistance.

When banks stopped providing short term liquidity to other banks and industrial companies, central banks filled the gap.

But such criticism ignores the problems faced by banks that did not use or deal in complex financial products.

Banks incurring balance sheet damage will have to be recapitalized.