Wednesday, January 20, 2010

Banking and Capitalism, as in Crony and Capitalism

Obama is again attacking bankers as a politically expedient scape goat as anger over bank bonuses spreads by proposing a bank tax. Interestingly, in 2009, Obama was worried about bank losses, now he complains about bank profits. However, I have noticed a trend among some libertarian leaning bloggers to be a bit non-chalant about this issue because they just see it as the free market at work. I beg to differ and emphatically. Although Obama's bank tax is a horrid idea, because it plays investors for suckers, (or Chicagoans), Republicans better come up with a plan to deal with the moral hazard, see Dean' video post.

Why is there outrage over bank bonuses in the first place? Because the taxpayers are being played for suckers. The banks made risky loans and fobbed off the risk to taxpayers, were bailed out with taxpayer dollars and now those same executives are rewarded with big bucks. Left, right or libertarian, who can't be outraged. But Obama tipped his hand in the waning days of the Massachusett Senate election that he is going to use Republican opposition as evidence of Republicans continuing to favor Wall Street over Main Street, and to be fair, he has a point. John Stossel has an excellent review of crony capitalism in general, but I want to focus on what to do about the banks.

It is too simple to just say that government shouldn't bail out the banks. It is widely understood that a series of bank failures has serious implications for the economy as a whole and no one is really going to risk finding out what would happen if a half dozen of the country's largest banks went bust. The bankers themselves are aware of this. Further, the bigger a bank gets, the more likely it will be seen as "too big to fail." This drives down its cost of obtaining funds, as investors realize there is little downside to investing in the biggest banks. This allows the big banks to get bigger, exacerbating the problem.

What to do? All banks are required to keep capital reserves to preserve system stability. These reserves, are of necessity, much less than the total amount of loans outstanding; if the reserve requirement were 100%, how could they make loans? Reserve requirements are more typically below 20%, (this is not my area of specialty, so see the wiki article for more.) In my view, a simple way to reduce the moral hazard and simultaneously remove the funding advantage of the big banks is to increase the reserve requirements as a banks size increases. While this sounds simple it would certainly be tricky in practice. How would one measure size for example, on an absolute or relative scale? However, I believe that such a system is achievable and would have the salutary effect of making the larger banks more safe, not less, as they increased in size. It would also increase the cost of capital as banks exceeded threshold size, thereby limiting the positive feedback effect that allows the largest banks to have the lowest cost of funds and continue to grow unchecked. Republicans need to get in front of this issue, because I think that Obama will be able to get traction against them if they don't.


  1. It would be interesting to find out if Obama knows that taxes come from profits and then ask him how he plans to hand out the goodies once the last profitable company has been righteously smitten down.

  2. I think Republicans should support Obama's two new bank proposals:

    1) separating the taxpayer-guaranteed, Fed-subsidized banks from the speculative investment banks

    2) limiting leverage at the TBTF banks. If it's obvious we're going to bail them out, we have to reduce that risk.

    Shoulda been done long ago.

    Republicans can both do the right thing and the populist thing, and be magnanimous and bipartisan.

  3. KT,
    My beef is that the profits look like they accrue to taxpayer guarantees, as well as previous bail outs. I'm not expert enough to say for sure, but it sure looks like that.

    I agree with separating out guarantees from speculation. I hope I communicated in my modest proposal that it was for the express purpose of limiting the TBTF leverage, so as to ensure stability.