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JakilaTheHun (99.93)

FDIC, Moral Hazard, and "Too Big to Fail"

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March 14, 2012 – Comments (31) | RELATED TICKERS: BAC , C , WFC

From Malthusian Nectar

 

The relationship between FDIC insurance, large banks, and the concept of “Too Big To Fail” (TBTF) is one of the more troubling aspects of our financial system.  What most people don’t understand is that FDIC insurance is one of the primary drivers behind this TBTF concept.  FDIC undermines market forces in regards to risk management and subsidizes the large banks as a result.

Some have advocated eliminating FDIC to fix this issue, but I also see that as somewhat undesirable and difficult to implement. It’s true that consumers would help keep banks a bit more accountable in a completely unregulated system, but here’s the thing: I have analyzed banks for a living. If I’m not an “expert”, I’m at least more knowledgeable than 99.9% of the population. And it’s very difficult for me to say with a high degree of certainty which banks are safe and which ones aren’t in a crisis setting.

I can look at capital ratios, past loan performance, and other financial metrics, but all of that is “past performance” and none of that tells me if the bank recently lent out to a massive number of non-creditworthy customers . And if I’m better than 99.9% of the population at assessing this and I can’t even give you a good answer, than how does the other 99.9% fare?  This is simply an issue that requires a lot of expertise and your average depositor lacks that.

So deposit insurance, minimal capital ratios, and some sort of basic ground rules seem vital to me, in order to ensure the soundness of the banking system. But that doesn’t mean that our current system totally works.  While I'd hold the American banking system high above almost all the systems of Europe and much of Asia, as well, it still has some significant issues.  And we're moving in the wrong direction right now. 

The primary Congressional response to the financial crisis was Dodd-Frank.  Unfortunately, Dodd-Frank is a complete disaster and actually makes the TBTF issue worse, not better. It also makes small banks less competitive, which is precisely the opposite result a free market would yield.  More importantly, it's this sort of result that puts the taxpayers in greater danger. 

If I had my druthers, I think I’d go a much different way with banking reform. I would radically change the nature of FDIC. Instead of being a direct insurer, the FDIC should instead require the banks to purchase deposit insurance from a *private* insurer. 

Why would this system be superior? For one, part of my thesis on why FDIC distorts the market is because the insurance rates don’t take into account the concept of systemic risk. We treat a small community bank and a giant mega-bank such as Citi or BofA as exactly the same under the current regulations. This is a competitive advantage for the mega-banks, because they create much higher risk, yet aren't required to pay higher prices to reflect this risk.  In essence, they are being subsidized by the Federal government via the FDIC program.

Of course, there are other issues with the FDIC, as well.  As we've seen over the past few years, the nature of the failed bank sales ends up relying, at least in part, on political connections.  For that matter, we've seen that political relationships often end up being important to how the FDIC treats a bank.  All in all, there are a lot of issues with FDIC that the general public simply does not see. 

If you shift the market over to private deposit insurance, the private insurers are going to be much pickier about the rates they charge and the risks they take on.  They are also going to be pickier about how they wind down a bank and sell off its assets.  It’s also going to make it very difficult for Citi and BofA to insure their own deposits. They might have to contract out several insurance companies and it’s likely that it’s going to be somewhat costly and force them to become more accountable to market forces.

There are some kinks to work out in this proposal, but I definitely view the moral hazard created by the FDIC’s subsidies as one of the primary reasons we have this TBTF problem. We have to restore market forces in deposit insurance or this moral hazard will continue.

31 Comments – Post Your Own

#1) On March 14, 2012 at 12:39 PM, chk999 (99.97) wrote:

Interesting approach to the problem. But it has to be handled in such that ordinary depositors do not lose their money. And the reason for that is that if small depositors can lose their money then bank runs become common again. Any negative publicity can cause a run. This makes the banking system too fragile. We really don't want that.

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#2) On March 14, 2012 at 1:00 PM, JakilaTheHun (99.93) wrote:

chk999, 

You're right --- preventing bank runs is the primary goal of the FDIC. 

Basically, I'm advocating shifting to an auto-insurance model.  States normally require that drives purchase auto insurance to drive on the roads, but you don't purchase the auto insurance from a state run corporation.  You purchase it from private insurers. 

The FDIC should have its role minimized, and basically set a broad set of insurance standards and capital requirements --- but ultimately, private insurers should be doing the primary work here. 

Of course, the private insurers could theoretically go bankrupt, too, but there is a check and balance on that.  The banks themselves are unlikely to buy insurance from a firm that has a weak balance sheet, just as the insurers are less likely to insure a bank with a weak balance sheet. 

That check and balance is missing in the current system. 

 

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#3) On March 14, 2012 at 1:01 PM, ETFsRule (99.94) wrote:

"If you shift the market over to private deposit insurance, the private insurers are going to be much pickier about the rates they charge and the risks they take on. "

It might work a little better, but you are really just shifting the responsibility from one type of banker to another. The large banks (lenders) are supposed to understand risk management. I'm not sure these private-sector insurers would be much better at it.

We would probably need someone else to insure the insurers, and that would be the gov't, creating the same moral hazard again.

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#4) On March 14, 2012 at 1:18 PM, JakilaTheHun (99.93) wrote:

The large banks (lenders) are supposed to understand risk management. I'm not sure these private-sector insurers would be much better at it.

The large banks *DO* understand risk management.  They understand that if they take risk, they receive the potential rewards, and taxpayers backstop potential losses. It's win-win, which isn't how it should be.

Private insurers that either profit or lose money based on the fortunes of their banking clients are going to have every incentive in the world to understand the banks they insure.  Much more so than the FDIC.  In a sense, the private insurers would almost be like auditors.

There's no reason the private insurers would have less expertise than the FDIC.  In actuality, they'd probably try to hire FDIC people to work for them.  But there'd be a difference:  the examiners would now be compensated based on how they perform, incentivizing them to be more critical and less political. 

We would probably need someone else to insure the insurers, and that would be the gov't, creating the same moral hazard again.

Not really.  You could set minimum capital requirements for the insurers and insurance is already a highly regulated industry. 

More importantly, banks aren't as likely to buy deposit insurance from weak insurers.  Banks and insurers would keep each other accountable in this scenario.

 

Most of the criticisms I read of this sort of idea involve a basic misunderstanding of what FDIC does.  FDIC does not do anything that is any more complicated than the private sector does already.  And part of the problem with FDIC is that it's a government guaranteed monopoly, so if an auditor dislikes the executives at one bank, they are more likely to get a nasty letter from the FDIC --- and no recourse. Yet, this has nothing to do with the actual risk of the banks' assets. 

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#5) On March 14, 2012 at 4:26 PM, valuemoney (99.99) wrote:

A guy came on CNBC and stated Dodd-Frank should have only needed to be 2 pages long.

Page 1

Everyone who wants to purchase a house need to put 20% down no questions asked and that is stapled directly to the loan so the original loan cant be doctored by selling and reselling the loan.

Page 2

Each bank needs to have 8% to 10% in capital reserves.

Ask yourself would the financial crisis ever happened if these 2 requirements were always met? It sounds simple and it is. You dont need a 2500 page report (of laws and requirements) that no one understands.

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#6) On March 14, 2012 at 4:47 PM, valuemoney (99.99) wrote:

FDIC is great in my opinion. It makes one feel safe and you should feel that way. Too big to fail should be in place. Why wreck a great system just because every panics at one time? Moral Hazard is if one would wreck the idea of free market capitalism just because of some sort term panic. Ask yourself is everything ok now. Sure it is. Now if the government left everything work out in the marketplace I would bet we would be in a severe depression with unemployment at least double what it is now. The fact is only one backer can handle this kind of financial pressure the US government and ALL ITS PEOPLE. United we stand divided we fall. Ok that sounded a little corny but I think everyone gets the picture.

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#7) On March 14, 2012 at 6:49 PM, Mega (99.96) wrote:

"More importantly, banks aren't as likely to buy deposit insurance from weak insurers.  Banks and insurers would keep each other accountable in this scenario."

Some banks would hire weak insurers for the lowest possible price.  Few customers pay attention to their bank's condition - even fewer would pay attention to their bank's deposit insurance company.  Until they lose all their money!

Also, compare your idea to MBI, ABK, PMI, RDN, MTG, etc.  After massive losses in the credit insurance industry which discredited their business model, I doubt there is much enthusiasm for creating a whole new industry similar to that.

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#8) On March 14, 2012 at 7:01 PM, JakilaTheHun (99.93) wrote:

MegaShort,

That criticism is a bit illogical.  You assume that the weakest insurers would offer the lowest prices, but it would be the exact opposite.  The weaker insurers would be forced to pass on higher costs for weaker underwriting standards.  

The banks that received the lowest rates would be the ones with the strongest balance sheets.  Insurers wouldn't simply offer "cheap rates" for the hell of it.  They have to turn a profit, and they can't turn a profit by offering cheap rates to banks with high risks. 

How do I know this?  Because that's exactly how it works with auto insurance, as well.  

Progressive is a great example.  They have lower rates than many insurers, because they are better at assessing the risk factors of drivers.  In insurance, better risk evaluation = lower costs.

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#9) On March 14, 2012 at 7:35 PM, Mega (99.96) wrote:

"The weaker insurers would be forced to pass on higher costs for weaker underwriting standards."  

Yes, that would be the logical thing for them to do.  But insurers in weak financial condition are usually poorly managed and illogical.

AIG, Ambak, PMI, etc. had competitive rates.

Correction in the insurance market can be a slow and painful process.  The problem is worse when counterparties don't have the knowledge or interest in assessing their condition (clearly the case with deposit insurance).  It is also worse when there are long periods between losses (credit, deposit insurance, catastrophic re) than when there are short periods (life, health, auto, P&C).

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#10) On March 15, 2012 at 1:13 AM, Option1307 (29.70) wrote:

Really good stuff and seems pretty logical, +1.

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#11) On March 15, 2012 at 10:28 AM, Valyooo (99.37) wrote:

I agree with you completely.  However, do you think fractional reserve banking would be possible without FDIC?  It seems that historically, frac banking ends in horrible disasters, with a run on pretty much every bank ever at some point in time.  Not saying we should have FDIC, just saying maybe we should not be frac banking.

 

Since you are the bank analyst expert...what is WFC and USB doing that is so good that they are the big boy on the block?  I understand what citi and bofa are doing wrong and what jpm and a few smaller banks are doing right, but whats going on with those guys that are good?

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#12) On March 15, 2012 at 11:53 AM, JakilaTheHun (99.93) wrote:

Valyooo,

I have no clue.  I don't consider myself an "expert" on banks and even if I did, I don't think anyone can realistically analyze the megabanks.  Even analyzing smaller banks can be difficult, but it's pretty much impossible to do more than take a guess on the megabanks.  And I'm OK with guessing on them sometimes if I believe the potential reward is high enough.

A lot of people are opposed to fractional reserve banking, but my issue is that I'm not sure that there are any great examples of an alternative system.  If I could see a clear plan to eliminate it that would work, I'd be interested. 

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#13) On March 15, 2012 at 12:06 PM, Valyooo (99.37) wrote:

Full reserve banking seems to be perfectly fine to me.

But anyway, without FDIC, frac banks are by definition insolvent at all times.  The only reason frac banks ever help up before FDIC, is because nobody knew they were frac banks...they claimed to be full reserve and they lied.

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#14) On March 15, 2012 at 12:15 PM, JakilaTheHun (99.93) wrote:

Valyooo,

But that's sort of my point.  I've heard a lot of proposals to eliminate frac reserve, yet I see no examples of full reserve banking, leading me to believe that the market may simply not tolerate it.  Consumers would have to take lower interest rates as a result, meaning that there's a strong disincentive towards ever accepting this system.

This is probably one of the few areas where I seem to disagree with Milton Friedman on --- but I can see no examples or any evidence that full reserve banking is plausible or beneficial.  I've tried to find good arguments in favor of it, but they all seem rather skeletal and seem to gloss over the real world consequences. 

I am stuck on the issue as to why I would put my money in a bank, only to have it sit there and generate no interest.  The bank would have to charge me a high fee to do this, and it would seem to result in an enormous amount of unutilized assets. 

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#15) On March 15, 2012 at 12:27 PM, Valyooo (99.37) wrote:

Actually, interest rates would be a lot higher I would think, since there would be less available capital.  Looking at full reserve banks and debts from the 1600 it seems as though a lot of it was in the high teens...look at how much excess capital we have now, which is why rates are so low.  Somebody loses, somebody wins.  Either consumers have less incentive to save, or borrowers have less incentive to borrow...the rate itself should not make a difference, it is just a shift.

 Your money does not have to earn zero interest.  If you put it into a CD, it would earn you interest, and they can lend that out.  Any money you need liquid to spend is in the checking, and you would of course pay a fee for it.  What would you rather, pay a small fee to have a checking account, or be forced to walk around with wads of cash, and stash the rest in your house, which is not safeguarded as well as a bank is?  Checking is a servive provided, it makes sense to pay for it.  The only reason you think it sounds weird now is because you are not used to it.  But on the flipside, it is actually hurting you to have a free account, because the frac banking is ruining the economy, so its an invisible banking fee, kind of like inflation is an invisible tax.

 You can say full reserve banking is not plausible, but that is not due to the theory, it is due to how the world works.  World peace is a solution to violence, which is why we strive towards it, but it is not plausible...doesn't mean we should institue violence though, just because that is what seems to happen, you know what I mean?

 

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#16) On March 15, 2012 at 12:53 PM, JakilaTheHun (99.93) wrote:

Actually, interest rates would be a lot higher I would think, since there would be less available capital.

The bank would charge higher interest rates to customers.  But depositors would not receive higher interest rates.  Banks generally have interest spreads ranging from 250 - 400 basis points.   No one is going to accept that low of a return without leverage to enhance it. With full reserve banking, the spreads would have to increase to something like 1200 - 1600 basis points.

 

What would you rather, pay a small fee to have a checking account, or be forced to walk around with wads of cash, and stash the rest in your house, which is not safeguarded as well as a bank is?

I would rather the bank lend the money out, so that I don't have to pay for checking, and I can take out a home loan at a lower interest rate.  That's what's in my best interest as a consumer. 

 

The only reason you think it sounds weird now is because you are not used to it.

I don't think it sounds "weird."  I think it sounds unbeneficial.  There's a difference.

If I wanted to deposit my money in a full-reserve bank, there's no law prohibiting me from doing that right now.  Yet, there are no full-reserve banks, because no one desires to *pay* for a checking account, while the bank lends out at 16% interest rates.   

But on the flipside, it is actually hurting you to have a free account, because the frac banking is ruining the economy, so its an invisible banking fee, kind of like inflation is an invisible tax.

Not really.  It's not as if assets are created out of thin air.  They simply lend out assets that are already in existance; making the bank less liquid, but allowing it to more fully utilize its resources.  This is pretty much how nearly every American company functions. 

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#17) On March 15, 2012 at 4:55 PM, Valyooo (99.37) wrote:

I don't think it sounds "weird."  I think it sounds unbeneficial.  There's a difference.

If I wanted to deposit my money in a full-reserve bank, there's no law prohibiting me from doing that right now.  Yet, there are no full-reserve banks, because no one desires to *pay* for a checking account, while the bank lends out at 16% interest rates.   

You're missing my point.  The only reason nobody DOES go into a full reserve bank account to make a deposit where they have to pay for the account, is BECAUSE the FDIC insures the fractional reserve banks. There is no need to worry about the frac reserves; they are guaranteed by the government.  If there was no FDIC, then people would choose the full reserve banks, as they have done every other single time in history.  Nobody liked frac reserves, and they were actually illegal in many countries, and the countries where both existed without FDIC, the full reserve was more popular. 

 

Think about this:

You walk down the street, there are two banks side by side.  One says "We charge $20 a month for checking accounts".  The other says "We don't charge anything for checking accounts, but we do not guarantee we won't lose your money, or lend more than we have, therefore your funds may be unavailable to you at our discretion".  Would you choose the $20 a month for the protection of not losing all of your assets?  If you have ever bought any type of insurance in your life, I would guess the answer would be yes.

 

Not really.  It's not as if assets are created out of thin air.  They simply lend out assets that are already in existance; making the bank less liquid, but allowing it to more fully utilize its resources.  This is pretty much how nearly every American company functions. 

Not true.  They are not lending out only the available cash.  They are lending out bank credit, which far exceeds total deposits.

 The bank would charge higher interest rates to customers.  But depositors would not receive higher interest rates.  Banks generally have interest spreads ranging from 250 - 400 basis points.   No one is going to accept that low of a return without leverage to enhance it. With full reserve banking, the spreads would have to increase to something like 1200 - 1600 basis points.

There would just be less banks.  If a bank had $10 trillion in assets, I think they could live with a spread of 325 basis points.  Plus, they can use leverage; they just have to float debt to the public and use it to invest.  Just no bank credit.

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#18) On March 15, 2012 at 5:17 PM, JakilaTheHun (99.93) wrote:

You're missing my point.  The only reason nobody DOES go into a full reserve bank account to make a deposit where they have to pay for the account, is BECAUSE the FDIC insures the fractional reserve banks.

No, it isn't.  Fractional reserve has been the norm in virtually every developed economy since the 19th Century.  It predated the FDIC and has absolutely nothing to do with the FDIC.  A bank could simply purchase private insurance rather than FDIC insurance if the government did not mandate it. 

 

There is no need to worry about the frac reserves; they are guaranteed by the government.  If there was no FDIC, then people would choose the full reserve banks, as they have done every other single time in history.

If "every other single time in history" is limited to a select number of situations in the 18th Century, this is true.  Otherwise, it's not.  Full reserve isn't used anywhere, except possibly in some undeveloped economies, where risks are sky-high even in full-reserve lending. 

 

 One says "We charge $20 a month for checking accounts".  The other says "We don't charge anything for checking accounts, but we do not guarantee we won't lose your money, or lend more than we have, therefore your funds may be unavailable to you at our discretion".  Would you choose the $20 a month for the protection of not losing all of your assets?  If you have ever bought any type of insurance in your life, I would guess the answer would be yes.

That situation would never arise, becuase you're ignoring the other side of the equation.  If one bank offers you a home mortage at 5.0% and the other offers it at 16.0%, which do you select?  Almost definitely, you chose the 5%  mortgage.

The bank with the 5% mortgage can pay out its depositors 2%, while it's completely plausible that the full reserve bank pays 0% interest. So once again, the depositors might chose the 2%.

If the FDIC did not exist, would this situation change?  Maybe slightly.  The bank could still purchase private insurance, however.  Also, it would put more pressure on the bank to maintain adequate capital ratios.  But it wouldn't change radically, except maybe at the big banks, which would have more difficulty obtaining private insurance. 

 

My issue with the idea of "full reserve banking" is that I've not yet heard a single person articulate how it would work in any reasonable fashion. 

Is "full reserve banking" actually a restriction on commerce?  What if a bank wants to do fractional reserve lending and insures its deposits with a private insurer; if they offer me better terms, and lend out at better rates --- am I restricted from taking this offer as a consumer?

To my understanding, "full reserve lending" is just another way of saying, "we should ban certain types of banking and prohibit market participants from chosing the best options for themselves."

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#19) On March 16, 2012 at 10:33 AM, Valyooo (99.37) wrote:

No, it isn't.  Fractional reserve has been the norm in virtually every developed economy since the 19th Century.  It predated the FDIC and has absolutely nothing to do with the FDIC.  A bank could simply purchase private insurance rather than FDIC insurance if the government did not mandate it. 

But why would you ever purchase private insurance when FDIC is free?  It has been the 'norm' for what, 100 years without FDIC?  Full reserve banking was the norm for over 1000 years, which is 10x longer than your norm

 If "every other single time in history" is limited to a select number of situations in the 18th Century, this is true.  Otherwise, it's not.  Full reserve isn't used anywhere, except possibly in some undeveloped economies, where risks are sky-high even in full-reserve lending. 

But...what if "every other single time in history" was NOT only situations in the 18th century, and instead was exactly what I said?  Read "money, bank credit, and economic cyc;es".  It is a looooong book but it cites many, many examples over the course of I belive 2-3000 years, and they were all suppsoed to be full reserve, but the banks tended to lie after a while and start lending more.

That situation would never arise, becuase you're ignoring the other side of the equation.  If one bank offers you a home mortage at 5.0% and the other offers it at 16.0%, which do you select?  Almost definitely, you chose the 5%  mortgage.

The bank with the 5% mortgage can pay out its depositors 2%, while it's completely plausible that the full reserve bank pays 0% interest. So once again, the depositors might chose the 2%

This doesn't even make sense.   Why would a full reserve bank have to charge 16% for a mortgage?   If a bank took in 300 billion in checking balances (which they dont lend out, they hold for a fee) and charged a 1.5% yearly fee, that is a 4.5 billion dollar profit, minus salaries.  Then if they had 300 billion in CDs and savings, and paid 0.5%  on it, and lent out the mortgage at 4.5%, that is 12 billion in more profit, minus salaries. So that is 16.5 billion in profit, using less assets than the megabanks have, and not including 1) credit cards 2) business account fees 3) overdraft fees 4) trading profits 5) investment banking profits

They would lend less money, but they wouldn't have to face as much regulatory pressure which would save money, they would generate a lot more in fees, etc

 To my understanding, "full reserve lending" is just another way of saying, "we should ban certain types of banking and prohibit market participants from chosing the best options for themselves."

Throughout history, frac banking was a fraudulent practice.  Free market participants also steal, rape, murder, light villages on fire, etc.  Guess we shouldn't ban those either?

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#20) On March 16, 2012 at 11:09 AM, Mega (99.96) wrote:

Valyooo, once you apply a 50% operating margin to $16.5B that's $8.25B in profit.

If your hypothetical bank has $300B in equity, that's a 2.8% return on equity.

Businesses in other industries can earn much higher ROE than this, so nobody would run a bank at these rates.

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#21) On March 16, 2012 at 11:44 AM, Valyooo (99.37) wrote:

8.25 / 600 billion = 1.3% ROA. Most banks aim for 1% ROA (and I don't think any of the mega banks even have that)  Plus, this didnt include any of the extra things I mentioned, liek credit cards, other fees, investment banking, and trading, which could add another 50-100% for the profit.

 The reason banks have high ROE is because they have little equity, and a lot of leverage.  ROE is not a good value metric for banks.

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#22) On March 16, 2012 at 12:08 PM, Mega (99.96) wrote:

You are incorrect, ROE is an appropriate metric for banks and the best way to compare financial companies with nonfinancial companies.

If you had $300B, would you start a bank that could expect to earn 2.8% ROE?  Or would you start another company that could expect to earn 8% ROE?

Your hypothetical numbers are wrong and don't come anywhere close to historical full reserve interest rates.

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#23) On March 16, 2012 at 12:12 PM, DJDynamicNC (25.84) wrote:

The issue here is that you're proposing simply passing the potential failure point somewhere further up the chain. We require banks to use private insurance - and then if a number of banks fail and they all draw on the same insurer, then that insurer fails.

The FDIC was created in response to the Depression-era bank runs and was designed to address systemic risks. That is a role government can and should play.

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#24) On March 16, 2012 at 1:43 PM, JakilaTheHun (99.93) wrote:

But why would you ever purchase private insurance when FDIC is free?

FDIC isn't free.  Read through some small bank financial statements.  Many of them will explictly list their FDIC fees in the income statements.  

Or you could directly see them at the FDIC website.  

FDIC is a publicly-run corporation.  It's supposed to break-even and it does that by charging fees to banks for its insurance services. 

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#25) On March 16, 2012 at 3:34 PM, Valyooo (99.37) wrote:

You are incorrect, ROE is an appropriate metric for banks and the best way to compare financial companies with nonfinancial companies.

If you had $300B, would you start a bank that could expect to earn 2.8% ROE?  Or would you start another company that could expect to earn 8% ROE?

Your hypothetical numbers are wrong and don't come anywhere close to historical full reserve interest rates.

No, YOU are incorrect. Nobody uses ROE for banks...it does not make sense.  Banks have too much leverage.  People used ROE prior to 2007.  Managers started leveraging up like crazy to make the ROE look better, that did not turn out so well.  BAC had a pheomenal ROE, and a terrible ROA...how did they do?  Not so well.

 Also your example is not a good one.  Would I start a bank or another company?  Well, if I started another company, it would not be so easy to gather $600 billion in assets would it?  banks earn ROA that is low because their asset base is much bigger, and it takes much less people to manage it than it would to manage $600 billion worth of crane production or some other non-bank business.

The FDIC was created in response to the Depression-era bank runs and was designed to address systemic risks. That is a role government can and should play.

The government is also the same body that allows for frac banking in the first place. So yes, the government is very good at playing the hero role after they create their own disasters.

FDIC isn't free.  Read through some small bank financial statements.  Many of them will explictly list their FDIC fees in the income statements.  

Well, I learn something new every day.But a private corporation would not seek to simply break even, they would charge more.  Therefore, the FDIC is subsidized.  So a subidized company gets to charge less, creating an unfair advantage.

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#26) On March 16, 2012 at 3:39 PM, Valyooo (99.37) wrote:

http://thinkprogress.org/yglesias/2011/10/26/354002/return-on-equity-versus-return-on-assets/?mobile=nc

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#27) On March 16, 2012 at 4:43 PM, Mega (99.96) wrote:

"Nobody uses ROE for banks...it does not make sense."

LOL.  Tell that to Warren Buffett.

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#28) On March 16, 2012 at 7:31 PM, Valyooo (99.37) wrote:

This is straight from investopedia:

"Buffett focuses on return on equity (ROE) rather than on earnings per share. Most finance students understand that ROE can be distorted by leverage (a debt-to-equity ratio) and therefore is theoretically inferior to some degree to the return-on-capital metric. Here, return-on-capital is more like return on assets (ROA) or return on capital employed (ROCE), where the numerator equals earnings produced for all capital providers and the denominator includes debt and equity contributed to the business. Buffett understands this, of course, but instead examines leverage separately, preferring low-leverage companies. He also looks for high profit margins.


Read more: http://www.investopedia.com/articles/05/012705.asp#ixzz1pKFTP4RN"

 

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#29) On March 17, 2012 at 1:28 PM, JakilaTheHun (99.93) wrote:

Valyooo,

You're mistaking two completely different concepts:

(1) Evaluating the operating effectiveness of a company

(2) Evaluating the real returns to equity holders

ROA and ROCE are great metrics to look at operating performance of a company.  But when you are evaluating the attractiveness of two alternative investments, you look at the ROE, because YOU ARE INVESTING EQUITY!

ROA allows you to see returns without leverage, to understand the underlying operational effectiveness of a company, but your actual returns in a leveraged investment are measured by ROE.  

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#30) On March 20, 2012 at 9:26 AM, Valyooo (99.37) wrote:

http://mises.org/daily/4880

This does a good job explaining why frac banking can never be the choice of the free market

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#31) On June 27, 2012 at 4:29 AM, williamsullivan8 (83.57) wrote:

Jakila, great post. Megashort, you bring up interesting points about the private insurance companies - if they are weak or poorly run (and what happened with the credit insurers in the financial crisis). 

Two points and a question for discussion:

Megashort, I once read a study (will post if I can find it posted online) that examined bank insurance during the early 1900's. If I remember correctly, government bank insurance before the FDIC was at the state level. The researchers found that states with government deposit insurance suffered larger monetary losses and a higher percentage of bank failures than states that did not have government deposit insurance. The evidence suggests that government guarantee does indeed encourage excessive risk taking, ultimately resulting in losses for taxpayers/citizens. A somewhat more privatized program would not be perfect, but it would alleviate this problem substantially. Overall, competitive insurance companies would probably also be able to price risk better than one giant government agency. Even though some of those insurance companies will be poorly run or make mistakes, the net losses of a bank would hit first hit bank shareholders, then insurance shareholders, then the government. That's more layers of protection. 

Jakila, nice comparison with auto insurance. However, the social costs of a few car accidents and a few banking failures are quite different. In the former, a much smaller number of people are affected by an uninsured driver, while a much larger number of people are affected by a failing bank, especially if that failure causes a confidence crisis or wider spread bank run. Also, banks are part of a country's currency system. Currency is a government function, so the government needs to be extensively involved. Perhaps the FDIC can act as a second layer of last resort insurance, with very low premiums for banks (since it only pays out if the private insurers fail as well). That way, competition and market forces will be increased, while consumers can feel extra safe about their savings. 

Question:  what do you think about the fundamental approach to banking regulation? It seems to me that US banking regulation is based on the "let's make a long list of very specific things that you can't do" approach. And some of the bankers regularly figure out loopholes to take risks they shouldn't. I think it would work a lot better to take the "you can do x, y, and z but nothing else" approach. Just like how the Constitution listed specific powers for the federal government and gave anything not mentioned to the states. This approach was pretty effective at preventing scope creep and loopholes. 

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