Broken Banks, Durable Delusions

Some 829 commercial banks are at risk of failure, according to the Federal Deposit Insurance Corp. This year 118 banks already failed and were taken over by the FDIC. At this rate, more banks will fail in 2010 than in 2009. If bank regulators were a commercial bank, they too would have gone bust. But being government entities, they prosper as the industry they oversee declines.

Investment banks dominated the public discussion in the run-up to the gigantic new financial regulation law. Regulation advocates argued that investment banks took excessive risk and needed to be more heavily regulated. Commercial banks were not the focus of the discussion—-because they have been heavily regulated since the early 20th century.

In fact, commercial banks are about as regulated as possible for private enterprises. Further regulation would turn them into an arm of the government—along the lines of mortgage financer Fannie Mae (FNMA), currently a black hole that sucks taxpayer money.

Commercial banking regulation has not prevented cyclical waves of bank failures. The previous one was the savings and loans crisis of the 1980s, when around one in every two savings and loan associations went bankrupt.

The reason banks fail is the same as it has always been since they’ve existed: they make bad loans, often in market conditions that encourage optimism. People have a penchant to be overly hopeful when markets go up. As a feature of human nature, this applies to everybody—-lenders, borrowers and regulators.

Having ever-larger contingents of regulators and bureaucratic procedures has not changed the basic cyclical pattern. Memories of past banking crises fade, the older generation retires and it looks like there’s a whole new world where the old strictures no longer apply—-see Jerry O’Driscoll’s review of This Time is Different by Reinhart and Rogoff. It looks that way not just to bankers but also to their regulators.

In the recent case, the real estate bubble, including the boom in commercial property, encouraged bad loans. The main regulator of the banking system, the Federal Reserve, far from trying to restrain banks, supplied the monetary fuel for the over-expansion of credit and the associated property bubble.

Nevertheless, the new law gives the Fed greater authority over investment banks on the ground that it will, or at least could or might, prevent future bank crises. Why did the Fed not do this with regard to commercial banks, for which it did not need additional authority? If the usual suspects – the Bush administration, Alan Greenspan – refused to take action, why didn’t Timothy Geithner, long-time head of the New York Federal Reserve Bank, say something?

He warned against the expansion of derivatives, but that was not an issue for small commercial banks. You can fail just as badly without touching any exotic derivative. There is no evidence that he was concerned about the twin credit and property bubbles or about the thousands of banks busily financing real estate by making old-fashioned loans.

It hard to see how the new regulatory powers Mr. Geithner defended as Obama’s Treasury secretary would have made any difference for the smaller banks in the boom/bust cycle. The Fed should obviously refrain from feeding bubbles, but for that it makes more sense to limit – not expand – its discretion.

None of this supports the belief that financial ills can be cured by extending government oversight. Yet that delusion retains its hold on many people’s minds even as packs of highly regulated banks go broke week after week.

Disclaimer: This page contains affiliate links. If you choose to make a purchase after clicking a link, we may receive a commission at no additional cost to you. Thank you for your support!

About Chidem Kurdas 58 Articles

Chidem Kurdas is a financial journalist, analyst and writer.

Throughout her career she has held numerous positions, including: Research Analyst at Thomson Reuters, New York Bureau Chief at HedgeWorld, News Editor at Infovest21, Senior Associate Editor at Medical Economics Publications at The Thomson Corporation. She is currently Editor at Opalesque Futures Intelligence.

She holds a PhD in Economics from New School University.

Visit: Mutual Fund Smarts

Be the first to comment

Leave a Reply

Your email address will not be published.


This site uses Akismet to reduce spam. Learn how your comment data is processed.