Edward Lotterman
Financial intermediaries that channel money from businesses and households desiring to save to others desiring to borrow perform a vital economic function.
Such flows of funds can facilitate great creation of wealth that can benefit all.
Indeed, much of the prosperity that we in the United States historically have enjoyed stems from sophisticated and effective privately held banks and financial markets that, on the whole, have allowed capital to flow to where it is most productive. Aside from creating the fiat currency, government need not be involved — to a point.
Unfortunately, such intermediation always involves risk. Loans from one small saver to a small borrower put the saver’s money at risk. They require time and effort to monitor. The same is true for rental properties or ownership shares in other businesses. That is precisely why private banking and investment firms handling savings, loans, stocks and bonds developed. They have economies of scale in assessing risk and in monitoring borrowers or businesses in which stakes have been purchased.
So savers and investors, large and small, can deposit money in a bank that thus handles risk assessment and monitoring. However, this does not end the risk. Banks inevitably still make some loans that are not repaid. Some investments don’t pan out. These defaults may be due to circumstances entirely beyond a borrower’s control, such as a farmer losing all their crops to hail. Or a bad business model. The loss may be ascribed to poor judgement but with no bad intent. And then there may be actual fraud — unlawful acts whether premeditated or impulsive.
Regardless of cause, however, banking systems could not function if any one bad loan or set of loans instantly translates into depositors being exposed to loss. Bank owners must have some of their own capital in their business and that equity grows over time. This owner equity serves as a cushion. When a loan is not repaid all deposits are still covered. The bank’s assets remain greater than its liabilities and it is solvent, at least as long as bad loans are less than the bank’s capital reserves.
However, solvency is not the only peril. There also needs to be liquidity. While most deposits are “demand deposits,” checking or savings accounts that can be emptied without warning, some may be in the form of certificates of deposit from which money cannot be withdrawn without penalty before a contractual amount of time passes. Regardless of how safe the loans made by the bank are, if a large number of depositors demand to withdraw their funds, the bank will not be able to come up with cash to satisfy them. The bank is solvent. Its assets do exceed its liabilities. But it is not liquid.
This was the situation for fictional banker George Bailey in the 1946 film “It’s a Wonderful Life,” and many movies and books about the Old West or the Depression era. Without any “lender of last resort” to tide a solvent but illiquid bank over a crisis, a bank would fail. Some depositors would, at best, get their money out only over time as the failed bank’s outstanding loans came due and were paid off.
This occurred most recently during the mortgage crisis of the late 2000s. Capital was invested in real estate loans predicated on the fallacy that the underlying collateral could only rise in value. When home prices tanked, it set off a chain reaction that toppled some of the most storied global investment banks and lenders. The lenders of last resort, in this case, was the U.S. Treasury and Federal Reserve.
But this has been true for most of our nation’s history.
In the “wildcat banking” era, two centuries ago, there were many states in which nearly anyone could open a bank. Not only could these accept deposits and make loans with virtually no oversight, they also could issue their own paper currency, “bank notes,” that were supposed to be redeemable for silver on demand. Often they were not.
With little control over who opened a bank and virtually no supervision afterward, putting money in a bank was fraught with danger. Moreover, it was dangerous for any person or business to accept payment in paper money about which they had no idea of its underlying value. This lack of information was an enormous drag on the economy.
Over time, regulation at the state and then federal level grew. But as recently as a century ago, before the Great Depression, nearly a third of all households lost some money in a failed bank.
The basic problem, in academic economic terms, is that information is incomplete, not available for all relevant issues. It also is asymmetric, with one side having more knowledge than the other.
That is not just true for banks. The same information problems appear in all other financial intermediation, stock and bond markets, mutual funds and the rest. Lack of reliable information is like ground glass in a gearbox. In the old days, why would someone buy a bond if they did not know whether the canal or railroad or steel mill it was funding would actually generate enough profits to pay interest and principal promised?
In the modern era, what about buying cryptocurrency, where the intrinsic value is based solely on the demand for crypto? Should one buy into some hedge fund making investments in “private credit” or “private equity” if the buyer really doesn’t understand what collateral these represent and only knows that the returns are high?
Can private market forces generate the needed information? Yes, to a point. In the 1840s, telephone-book sized quarterly reports detailed the varied relative values in silver of paper money issued by different banks. It took money to compile such directories, but these did not sell well if they proved inaccurate. Selling them generated revenue, but they were easy to pirate.
Today, companies with accounting expertise meticulously go over the financial statements of corporations or government entities issuing bonds or offering shares of stock. These firms assign ratings from AAA+ on down. As with the bank-note rating companies, bond-rating companies were vulnerable to plagiarism, so issuers of the bonds have to pay. The fact that ratings make it easier to sell bonds and at lower interest rates motivates issuers to pay for the service. But such ratings have long not been mandated by government.
But a lack of privately compiled objective, verifiable financial information, compounded by severe financial and economic crises, motivated government action. The Panic of 1907 let to creation of the Federal Reserve. The collapse of financial markets and thousands of bank failures after the 1929 Wall Street crash eventually brought about the “New Deal” — federal regulation of lenders, securities exchanges and federally administered insurance of some deposits.
As with many things, however, regulation began a whack-a-mole game that continues today, with financial firms searching for loopholes or creating new accounts, investment funds or securities that skirt regulation. Moreover, a populist political mindset opposed to regulation further compounds the risk. Does profit motive and potential market share force private markets to behave? It is not cynical at all to note that the opposite is true — these actors will misbehave if given the chance.
Consider how collateralized mortgage bonds bundled with other debt was all the rage 20 years ago — with disastrous results. Now, largely unsupervised funds invest in “private” loans or in “private” equity stakes, especially betting on the market potential of new high-tech startups (remember the dot-com bubble of the late ’90s?). These may turn out to be huge long-term moneymakers, supplanting similar rivals as the market shakes out — think Facebook vs. MySpace. But the losers may turn out to be like unexploded ordnance from World War II in European cities — unseen but with fuses that may explode with just a minor vibration.
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St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.
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