Wednesday, September 9, 2009

The Risks of Business As Usual in Banking

Banking today is structurally different from, say, three years ago. There are no more large brokerage firms under SEC regulation. All the major financial institutions are banks regulated by the federal banking authorities. There are notably fewer big financial institutions. Many faces in executive suites have changed.

But operationally, it would seem that plus ca change, plus c'est la meme chose. The banks still make big profits and pay big employee bonuses. They also take big risks. Today's Wall Street Journal reported on p. A1 that "value at risk," a measure of the potential for trading losses, is for the largest banks greater than it was in 2008, 2007 and even the boom year of 2006. In other words, after all the Federal Reserve accommodations, federal bailouts, bonus controversies, Congressional hearings and bank failures, business as usual continues and the banks are, if anything, putting taxpayers at greater risk than ever before.

That's bad, since business as usual is how we got into the recent credit crunch and Great Recession. Why haven't things changed? A couple of likely explanations suggest themselves. First, bank regulatory reform hasn't happened, and seems to be slipping toward the back burner. Health insurance reform is an extremely important priority, and, after eight years of meandering, the war in Afghanistan needs definitive direction. But let's remember that the current Great Recession was brought on by risky banking practices and more than anything the electorate chose Barack Obama as President to straighten out the economic mess. His administration cannot afford to lose focus of the need for financial regulatory reform. In the absence of reform, what else can we expect other than bad old business as usual?

The second likely explanation for the return and elevation of the banking system's risks is that the Fed, once again, is pumping out cheap credit. This time, it's really cheap credit, virtually free. Recall how banks make money. They borrow it (from depositors, commercial lenders, and nowadays most prominently the Federal Reserve) and lend it out or invest it. When the cost of borrowing is low, comparatively high risks seem sensible. (This is why so many people paid ridiculously high prices for houses when they could get 100% financing with interest only or option ARM loans--the credit was incredibly cheap so what did the price of the house matter?) High cost of funds imposes risk management discipline. Cheap money encourages profligacy.

How many times in the last decade or so have we seen this from the Fed? We've had the tech stock bubble, the housing bubble, the credit bubble, the 2008 petroleum bubble and now today's stock market, gold and who knows what else bubble. The Fed has made clear that it's going to keep credit cheap for an extended period of time. So why wouldn't the big banks ratchet up risk? Their costs are under control, courtesy of the Fed. And they know the taxpayers guarantee all their liabilities 100 cents on the dollar. What's not to like about risk? It's a great way to boost employee bonuses, when all goes well.

But the new data about banks taking more risk than ever raises the specter of another big asset bubble. If we are working our way toward another bubble, we'd better hope that this one defies the laws of economics and never pops. Since the Fed is already maintaining a zero interest rate for banks that borrow from it, it can't pull the nation out of another economic bust by lowering interest rates. There's no such thing as negative interest, because bank depositors will simply withdraw their funds and put the stuff in mattresses (which would mean the collapse of the financial system). The current combination of no bank regulatory reform, the cheapest credit possible from the Fed for an extended time, and a resumption and expansion of business as usual among the big banks could be deadly. With nothing changing, what can we expect except apres cette fois, le deluge?

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