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Why Do Banks Keep Going Bankrupt? – Article by Kirby R. Cundiff

Why Do Banks Keep Going Bankrupt? – Article by Kirby R. Cundiff

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The New Renaissance Hat
Kirby R. Cundiff
November 4, 2013
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The banking industry is unstable. Banks are regularly going bankrupt. Crises in the banking industry have occurred in three distinct time periods during the twentieth century—during the Great Depression of the 1930s, during the Savings and Loan crisis of the 1980s and 1990s, and during the Great Recession from 2007 to present.

Why the banking industry is so vulnerable to bankruptcies and what can be done to correct this problem?

Debt to assets, or leverage, ratios vary significantly from industry to industry. They are typically under ten percent in most high tech industries and go up to forty percent for public utilities. Average debt ratios in the banking and financial services industry are in the fifty to seventy percent range, however, and many banks have much higher leverage ratios.

Firms attempt to minimize their total financing costs or Working Average Cost of Capital (WACC). The component costs of capital (cost of debt and cost of equity) are determined by investors’ perceptions of the risk and return possibilities associated with buying debt or equity in a given company or individual.

A credit card loan has a higher interest rate than a home loan because the credit card loan is riskier—i.e. there are no assets to seize if the money is not paid back. Similarly, a high-risk company normally pays a higher interest rate on its debt than a lower-risk company and increasing leverage is normally associated with increasing risk. Due to deposit insurance, however, this isn’t the case with banks.

Moral Hazard

The Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 in the United States. Most of the European countries (including Cyprus) have similar organizations that insure deposits up to 100,000 EUR. (See Deposit Insurance.)

Since depositors believe that their bank accounts are insured by governments, they do not generally know or care how much risk banks incur when they invest their depositors’ money. This creates a moral hazard problem with very little oversight by depositors of a bank’s management of their assets. Bank managers can take a lot of risk and, if they make profits, they keep the money. If they lose money, the taxpayers pay for the losses. In theory, this moral hazard problem is mitigated by subordinated debt, investors with deposits over the deposit insurance limit, and banking regulations. But these approaches are clearly not working.

In a series of agreements called the Basel Accords, the Basel Committee on Bank Supervision (BCBS) provides certain recommendations on banking regulations in regards to capital risk, market risk and operational risk. The purpose of these accords is to ensure financial institutions have enough capital to meet their obligations. The Tier I and Tier II capital controls of the Basel Agreements are supposed to prevent banks from taking too much risk with depositors’ assets. Tier 1 capital consists largely of shareholders’ equity. Tier 2 capital comprises undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated debt.

The capital ratios are:

  •   Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets
  •   Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 + Tier 2) / Risk-adjusted assets
  •   Leverage ratio = Tier 1 capital / Average total consolidated assets

To be well-capitalized under federal bank regulatory definitions, a bank holding company must have a Tier 1 capital ratio of at least six percent, a total capital ratio of at least ten percent, and a leverage ratio of at least five percent (Capital).

The leverage ratios allowed under the Basel agreements are far higher than the typical leverag ratios in most industries and are far higher than would exist in a free-market financial system. Under a free-market system, depositors would not put their money in overly-leveraged banks and banks would be forced to decrease their leverage ratios and behave more like mutual or money market funds. Banks would be less likely to use short-term liabilities (deposits) to fund long-term assets (loans).

The S&L Crisis

Massive bank leverage would not create as much instability if the money supply was stable as in the 1800s under the gold standard. Under the current debt-is-money system, inflation and interest rates can vary wildly from year to year. The Savings and Loan Associations (S&Ls) made many low interest 30-year fixed rate home loans when inflation was low in the 1960s—five percent interest rate loans were typical. As inflation increased, the S&Ls still had these long-term home loans on their books, but the market now demanded higher interest rates on deposits (eighteen percent at times). The interest rates that many savings and loans were receiving on their assets (30-year fixed rate loans) were much lower than the interest rates the same S&Ls were paying on their liabilities (deposits). This duration mismatch resulted in the mass insolvency of the Savings and Loan Industry and a bailout of the S&Ls by the American tax payers exceeding $100 billion.

The Great Recession

The banking defaults of the Great Recession (2007 to present) were also caused by unstable interest rates combined with high leverage. The Federal Reserve lowered rates in the early 2000s to stimulate the economy after the bursting of the dot.com bubble. This resulted in many people borrowing money at very low interest rates to buy homes. Then the Federal Reserve raised interest rates and many people were no longer able to make their home payments. Again the result was massive bank insolvency and a substantial decrease in home values. Another huge taxpayer -funded bailout of the banking system followed, and the Federal Reserve has been printing money ever since, trying to stimulate the economy in the wake of yet another bubble it created.  The disbursements associated with placing into conservatorship government-sponsored enterprises Fannie Mae and Freddie Mac by the U.S. Treasury, the Troubled Asset Relief Program (TARP), and the Federal Reserve’s Maiden Lane Transactions are probably around $400 billion. How much of these disbursements will be paid back is currently unclear.

During the recent crises in Cyprus, proposals were seriously considered to ignore the 100,000 EUR deposit insurance and seize a fraction of even small depositors’ money. Most depositors lost access to their accounts for over a week and large depositors are still likely to lose a large fraction of their assets. This crisis has made some depositors more likely to pay attention to the solvency of their banks, but most depositors still believe that deposit insurance will cover any possible losses. If banks are to become more stable, the amount of equity relative to debt in the banking system must be drastically increased to something resembling what it would be without government deposit insurance, central bank subsidies, and treasury bailouts. Given the lobbying power of bankers in Washington, DC and around the word, such is unlikely to occur. The boom-bust cycle of banking bubbles followed by banking crises will most surely continue.

For further reading on this topic see this from The Freeman.

Kirby R. Cundiff, Ph.D. is an Associate Professor of Finance at the Rochester Institute of Technology. He is a Chartered Financial Analyst and a CERTIFIED FINANCIAL PLANNERTM Professional. 

This article was originally published by The Foundation for Economic Education.

 

Bitcoin for Beginners – Article by Jeffrey A. Tucker

Bitcoin for Beginners – Article by Jeffrey A. Tucker

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The New Renaissance Hat
Jeffrey A. Tucker
April 2, 2013
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Understanding Bitcoin requires that we understand the limits of our ability to imagine the future that the market can create for us.

Thirty years ago, for example, if someone had said that electronic text—digits flying through the air and landing in personalized inboxes owned by us all that we check at will at any time of the day or night—would eventually displace first class mail, you might have said it was impossible.

After all, not even the Jetsons cartoon imagined email. Elroy brought notes home from his teacher on pieces of paper. Still, email has largely displaced first-class mail, just as texting, social networking, private messaging, and even digital vmail via voice-over-Internet are replacing the traditional telephone.

It turns out that the future is really hard to imagine, especially when entrepreneurs specialize in surprising us with innovations. The markets are always outsmarting even the most wild-eyed dreamers, and they are certainly smarter than the intellectual who keeps saying: such and such cannot happen.

It’s the same today. What if I suggested that digital money could eventually come to replace government paper money? Heaven knows we need a replacement.

Solving Problems a Byte at a Time

Money started in modern times as gold and silver, and it was controlled by its owners and users. Then the politicians got hold of it—a controlling interest in half of every transaction—and look what they did. Today money is rooted in nothing at all and its value is subject to the whims of central planners, politicians, and monetary bureaucrats. This system is not very modern when we consider a world in which the market is driving innovations in other aspects of our daily lives.

Maybe it was just a matter of time. The practicality is impossible to deny: Gamers needed tokens they could trade. Digital real estate needed to be bought and sold. Money was also becoming more and more notional, with wire transfers, bank computer systems, and card networks serving to move “money” around. The whole world was gradually migrating to the digital sphere, but conventional money was attached to the ground, to vaults owned or controlled by governments.

The geeks went to work on it in the 1990s and developed a number of prototypes—Ecash, bit gold, RPOW, b-money—but they all faltered for the same reason: their supply could not be limited and no one could figure out how to make them impossible to double and triple spend. Normally, reproducibility is a wonderful thing. You can send me an image and still keep it. You can send me a song and not lose control of yours. The Internet made possible infinite copying, which is a great thing for media and texts and—with 3-D printing—even objects. But reproducibility is not a feature that benefits a medium of exchange.

After all, a currency is useless unless it is scarce and its replication is carefully controlled. Think of the gold standard. There is a fixed amount of gold in the world, and it enters into economic life only through hard work and real expenditure. Gold has to be mined. All gold is interchangeable with all other gold, but when I own an ounce, you can’t own it at the same time. How can such a system be replicated in the digital sphere? How can you assign titles to a fungible digital good and makes sure that these titles are absolutely sticky to the property in question?

Follow the Money

Finally it happened. In 2008, a person called “Satoshi Nakamoto” created Bitcoin. He wasn’t the first to solve the problem of double spending. A currency called e-gold did that, but the flaw was that there was a central entity in charge that users had to trust. Bitcoin removed this central point of failure, enabling miners themselves constantly to validate the transaction record. He had each user download the full ledger of all existing Bitcoins so that each could be checked for its title and not used more than once at the same time. With his system, every coin had an owner, and the system could not be gamed.

Further, Nakamoto built in a system of mining that attempts to replicate the experience of the gold standard. The math equations you have to solve get harder over time. The early creators had it easy, just like the early miners of gold could pan it out of the river, though later they had to dig into the mountain. Nakamoto put a limit on the number of coins that can be mined (21 million by 2140). (A new coin is currently mined every 20 seconds or so, and a transaction occurs every second.)

He made his code completely open-source and available to all so that it could be trusted. And the payment system used the most advanced form of encryption, with public keys visible to all and a scrambling system that makes its connection to the private key impossible to discover.

No one would be in charge of the system; everyone would be in charge of the system. This is what it means to be open source, and it’s the same dynamic that has made WordPress a powerhouse in the software community. There would be no need for an Audit Bitcoin movement. Trust, anonymity, speed, strict property rights, and the possibility that applications could be built on top of the infrastructure made it perfect.

Bitcoin went live on November 1, 2008. To really appreciate why this matters, consider the times. The entire political and financial establishment was in full-scale panic meltdown. The real estate markets had collapsed, pulling down the balance sheets of the major banks. The investment banks were unloading mortgage-backed securities at an unprecedented pace. Boats delivering goods couldn’t leave shore because they could find no backers for their insurance bonds. For a moment, it seemed like the world was ending. The Republicans held the White House, but the unthinkable still happened: Government and the central banks decided to attempt a full-scale rescue of the whole system, spending and creating trillions in new paper tickets to fill bank vaults.

Clearly government paper was failing. A digital alternative had to exist. But what gave Bitcoin its value? There were several factors. It was not fixed to any existing currency, so it could float according to human valuation. It was made from real stuff: the very 1s and 0s that were driving forward the global market economy. And while 1s and 0s can be reproduced unto infinity, the new coins could not, thanks to a system in which the coin and its public key were strictly controlled and the ledger updated for every transaction. Its soundness could be checked constantly through instantaneous conversion to other currencies as well as to goods and services. The model seemed impenetrable, the first digital currency that really addressed all the problems that had doomed previous attempts.

A Bitcoin of One’s Own

Let’s fast forward in time to March 2013. I had become the proud owner of my first Bitcoin. My wallet lived on my smartphone. Only three years ago, some wonderful applications had already developed around the currency unit. Although I’m a bit techy, I’m not a rocket scientist and I’m quite certain that I would have been out of my league. But this is how digital institutions develop to become ever more user friendly. At the same event at which I became a Bitcoin owner, I also used a Bitcoin ATM. I put in the green stuff, held my digital wallet up to the scanner, and then I felt the buzz on my smartphone. Physical became digital. Beautiful.

But still I wondered what exactly I could do with these things. That’s when the consumer world of Bitcoin products appeared before me. We aren’t just talking about the Silk Road—a website that became notorious for enabling the easy, anonymous buying and selling of drugs. There are Bitcoin stores everywhere. And there are services in which you can buy from any website with a Bitcoin interface. There was growing talk of Bitcoin futures markets. Some companies were rumored to be going public with Bitcoins, and thereby bypassing the whole of the Securities and Exchange Commission. The implications are mind-blowing.

Sacred Pliers

Still, I’m a tactile kind of guy. I need to experience things. So I went to one of these sites. I brought the first product I saw (why, I do not know). It was a pair of pliers for crimping electric cables. I put in my shipping address and up came a note that said it was time to pay. This was the moment I had been waiting for. A QR code—that funny square design that looks like a 3-D bar code—popped up onscreen. I held up my “wallet” and scanned. In less than 2 seconds, the deed was done. It was easier than Amazon’s one-click ordering system. My heart raced. I jumped out of my chair and did a quick song and dance around the room. Somehow I had seen it thoroughly for the first time: this is the future.

The pliers arrived two days later, and even though I have no use for them, I still treasure them.

Bitcoin had already taken off when the surprising Cyprus crisis hit in a big way. The government was talking about seizing bank deposits as a way of bailing out the whole system. During this period, Bitcoin essentially doubled in value. Press reports said that people were pulling out government currency and converting it, not only in Cyprus but also in Spain and Italy and elsewhere. The price of Bitcoin in terms of dollars soared. Another way to put this is that the price of goods and services in terms of Bitcoin was going down. Yes, this is the much-dreaded system that mainstream economists decry as “deflation.” The famed Keynesian Paul Krugman has even gone so far as to say that the worst thing about Bitcoin is that people hoard them instead of spending them, thereby replicating the feature of the gold standard that he hates the most! He might as well have given a ringing endorsement, as far as I’m concerned.

Obsession and Resentment

My own experience with Bitcoin during this time intensified. I began to call friends on Skype and scan their QR codes and trade currencies. I began to rope other people into the obsession based on my experience: you have to own to believe. After one full day of buying, selling, and using Bitcoins, I had the strange experience of resenting that I had to pay a cab fare in plain old U.S. dollars.

How do you obtain Bitcoins? This process can be a bit tricky. You can look up localbitcoins.com and find a local person to meet you to trade cash for Bitcoins. Usually, this exchange takes place at high premiums of anywhere from 10 percent to 50 percent depending on how competitive the local market is. It is understandable why people are reluctant to do this, no matter how safe it is. There is just something that seems sketchy about meeting a stranger in an all-night cafe to do some unusual digital currency exchange.

A more conventional route is to go to one of many online sellers and link up your bank account and buy. This process can take a few days. And then when you set out to transfer the funds, you might be surprised at the limits in the market that exist these days. Sites are rationing Bitcoin selling based on availability, just given the high demand. It could be 10 days or more to go from non-owner to real owner. But once you have them, you are off to the races. Sending and receiving money has never been easier.

Doubts?

As of this writing, a Bitcoin is trading for $88.249.  Just three years ago, it hovered at 0.14 cents. Many people look at the current market and think, surely this is a speculative bubble. That could be true, but it might not be. People are exchanging an unstable, fiat paper for something with a real title that cannot be duplicated. Everyone knows precisely how many Bitcoins exist at any time. Anyone can observe the transactions taking place in real time. A Bitcoin’s price can go up and down, and that’s fine, but there is no real speculation going on here that is endogenous to the Bitcoin market itself.

Is it a pyramid scheme? The defining mark of a pyramid scheme is that more than one person has an equal claim on the same money or good. This is physically impossible with Bitcoin. The way the program is set up, it is a strict property rights regime with no exceptions. In fact, in early March, there was a brief hiccup in the system when some new coins were approved by one group of developers but not approved by another. A “fork” appeared in the system. The price began to fall. Developers worked fast to resolve the dispute and eventually the system—and the price—returned to normal. This is the advantage of the open-source system.

But what about the vague sense some people have that a handful of coders cannot, on their own, cause a new currency to come in existence? Well, if you look back at what Austrian monetary theorist Carl Menger says, he points out that a similar process is precisely how gold became money. Every new currency is not at first used by everyone. It is at first used only “by the most discerning and most capable economizing individuals.” Their successful behaviors are then emulated by others. In other words, the emergence of money involves entrepreneurship—that is, being alert to opportunities to discover and provide something new.

Leviathan Leers

But what about a government crackdown? No doubt that attempt will be made. Already, some national government agencies are expressing some degree of annoyance at what could be. But governments haven’t been able to control the cash economy. It would be infinitely more difficult to control a virtual currency with no central bank, with encryption, and with millions of users per day. Controlling that would be unthinkable.

There was a time when the idea that ebooks would replace physical books was an absurd notion. When I first took a look at the early generation of ereaders, I laughed and scoffed. It will never happen. Now I find myself looking for a home for my physical books and loading up on ebooks by the hundreds. Such is the way markets surprise us. Technology without central planners makes dreams come true.

It’s possible that Bitcoin will flop. Maybe it is just the first generation. Maybe thousands of people will lose their shirts in this first go-round. But is the digitization of money coming? Absolutely. Will there always be skeptics out there? Absolutely. But in this case, they are not in charge. Markets will do what they do, building the future whether we approve or understand it fully or not. The future will not be stopped.

Jeffrey Tucker is executive editor and publisher at Laissez Faire Books. 

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Cyprus and the Unraveling of Fractional-Reserve Banking – Article by Joseph T. Salerno

Cyprus and the Unraveling of Fractional-Reserve Banking – Article by Joseph T. Salerno

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The New Renaissance Hat
Joseph T. Salerno
March 30, 2013
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[Originally posted on Circle Bastiat, the faculty blog of the Mises Institute. Read Circle Bastiat for Austrian analysis of current economic events from today’s top Misesian and Rothbardian economists.]

The “Cyprus deal” as it has been widely referred to in the media may mark the next to last act in the the slow motion collapse of fractional-reserve banking that began with the implosion of the savings-and-loan industry in the U.S. in the late 1980s.

This trend continued with the currency crises in Russia, Mexico, East Asia, and Argentina in the 1990s in which fractional-reserve banking played a decisive role. The unraveling of fractional-reserve banking became visible even to the average depositor during the financial meltdown of 2008 that ignited bank runs on some of the largest and most venerable financial institutions in the world. The final collapse was only averted by the multi-trillion dollar bailout of U.S. and foreign banks by the Federal Reserve.

Even more than the unprecedented financial crisis of 2008, however, recent events in Cyprus may have struck the mortal blow to fractional-reserve banking. For fractional-reserve banking can only exist for as long as the depositors have complete confidence that regardless of the financial woes that befall the bank entrusted with their “deposits,” they will always be able to withdraw them on demand at par in currency, the ultimate cash of any banking system.

Ever since World War Two governmental deposit insurance, backed up by the money-creating powers of the central bank, was seen as the unshakable guarantee that warranted such confidence. In effect, fractional-reserve banking was perceived as 100-percent banking by depositors, who acted as if their money was always “in the bank” thanks to the ability of central banks to conjure up money out of thin air (or in cyberspace).

Perversely the various crises involving fractional-reserve banking that struck time and again since the late 1980s only reinforced this belief among depositors, because troubled banks and thrift institutions were always bailed out with alacrity—especially the largest and least stable. Thus arose the “too-big-to-fail doctrine.” Under this doctrine, uninsured bank depositors and bondholders were generally made whole when large banks failed, because it was widely understood that the confidence in the entire banking system was a frail and evanescent thing that would break and completely dissipate as a result of the failure of even a single large institution.

Getting back to the Cyprus deal, admittedly it is hardly ideal from a free-market point of view. The solution in accord with free markets would not involve restricting deposit withdrawals, imposing fascistic capital controls on domestic residents and foreign investors, and dragooning taxpayers in the rest of the Eurozone into contributing to the bailout to the tune of 10 billion euros.

Nonetheless, the deal does convey a salutary message to bank depositors and creditors the world over. It does so by forcing previously untouchable senior bondholders and uninsured depositors in the Cypriot banks to bear part of the cost of the bailout. The bondholders of the two largest banks will be wiped out and it is reported that large depositors (i.e., those holding uninsured accounts exceeding 100,000 euros) at the Laiki Bank may also be completely wiped out, losing up to 4.2 billion euros, while large depositors at the Bank of Cyprus will lose between 30 and 60 percent of their deposits. Small depositors in both banks, who hold insured accounts of up to 100,000 euros, would retain the full value of their deposits.

The happy result will be that depositors, both insured and uninsured, in Europe and throughout the world will become much more cautious or even suspicious in dealing with fractional-reserve banks. They will be poised to grab their money and run at the slightest sign or rumor of instability. This will induce banks to radically alter the sources of the funds they raise to finance loans and investments, moving away from deposit and toward equity and bond financing. As was reported Tuesday, March 26, this is already expected by many analysts:

One potential spillover from the March 26 agreement is the knock-on effects for bank funding, analysts said. Banks typically fund themselves with some combination of deposits, equity, senior and subordinate notes and covered bonds, which are backed by a pool of high-quality assets that stay on the lender’s balance sheet.

The consequences of the Cyprus bailout could be that banks will be more likely to use contingent convertible bonds—known as CoCos—to raise money as their ability to encumber assets by issuing covered bonds reaches regulatory limits, said Chris Bowie at Ignis Asset Management Ltd. in London.

“We’d expect to see some deposit flight and a shift in funding towards a combination of covered bonds, real equity and quasi-equity,” said Bowie, who is head of credit portfolio management at Ignis, which oversees about $110 billion.

If this indeed occurs it will be a significant move toward a free-market financial system in which the radical mismatching of the maturities of assets and liabilities in the case of demand deposits is eliminated once and for all. A few more banking crises in the Eurozone—especially one in which insured depositors are made to participate in the so-called “bail-in”—will likely cause the faith in government deposit insurance to completely evaporate and with it confidence in the fractional-reserve banking system.

There may then naturally arise on the market a system in which equity, bonds, and genuine time deposits that cannot be redeemed before maturity become the exclusive sources of finance for bank loans and investments. Demand deposits, whether checkable or not, would be segregated in actual deposit banks which maintain 100-percent reserves and provide a range of payments systems from ATMs to debit cards.

While this conjecture may be overly optimistic, we are certainly a good deal closer to such an outcome today than we were before the “Cyprus deal” was struck. Of course we would be closer still if there were no bailout and the full brunt of the bank failures were borne solely by the creditors and depositors of the failed banks rather than partly by taxpayers. The latter solution would have completely and definitively exposed the true nature of fractional-reserve banking for all to see.

Joseph Salerno is academic vice president of the Mises Institute, professor of economics at Pace University, and editor of the Quarterly Journal of Austrian Economics. He has been interviewed in the Austrian Economics Newsletter and on Mises.org. Send him mail. See Joseph T. Salerno’s article archives.