Banking On It

When we are children, we conceive of banks as places to safely deposit money. If, by chance, you grew up watching It’s A Wonderful Life every Christmas, you probably have the idea that money deposited in banks is loaned out into your community:

If modern banking truly worked this way, you would understand that when people are unable to repay their loans, that the deposits might not be as safe as previously thought. To solve this, banks now also pay another company (The FDIC) to insure against deposits, so that depositors feel safe storing their money with the bank.

There are, of course, a few problems with this simplistic view of the banking system, as recent depositors in Iceland’s Kaupthing discovered. While some depositors quickly received their money from insurers, others weren’t quite as well insured, having deposited money in different jurisdictions, while other investors were technically bondholders and not depositors.

It will be 2017 by the time these depositors receive 80% of their money back – and they won’t be getting the remaining 20%… ever. Of course, the usual suspects are calling for a “bailout” of these depositors.

There are several issues that separate us from George Baily’s savings-and-loan conception of how banks should work. The insurance company scheme sounds like a great idea on paper. And, in truth, it has worked pretty well since its implementation. The problem, however, is that it really only protects against depositor losses during normal times.

For example, a fire insurance company looks up statistics on house fires in an area, and sets its premiums accordingly. The insurance company makes money, and homeowners feel safe that even if their house burns to the ground, they will be able to rebuild with the insurance payout. However, their feeling of safety should be mitigated by the realization that the insurance company itself could go bankrupt.

This is the case more often than we realize. When we buy fire insurance, we are adequately protecting ourselves from the chance that our house will burn down. We are not, however, protecting ourselves from the chance that our neighborhood will burn down – because of the high probability that the fire insurance company will owe too much money to too many people. Both we, and the fire insurance company underestimated the true risk.

The first sober realization we must make, is that we are currently facing a systemic threat to the banking system. In short, the whole neighborhood might go up in flames. If there were any doubt of this, we can simply look at how much money the FDIC has left to repay depositors. The answer is that they have none. To solve this, they are requiring banks to prepay their insurance premiums three years in advance – something not all of them will be able to do.

And yet, even this point of view  is both simplistic and optimistic. It’s not just that, as George Bailey said, the banks don’t have your money. In reality, they aren’t restricted to loaning out the money they take in deposits. They loan out many times the amount of deposits, and actually hold the deposits in reserve as “insurance” against the loans they make.

Worse still, the FDIC made a mistake early on, when they tried to stem the panic by repaying more than was insured to depositors. And worst of all, in case you forgot, banks weren’t merely loaning out money, but they were speculating wildly in derivatives that they still don’t understand, and still value at extraordinary optimistic levels.

Let’s put it this way, if your fire insurance company asked all of their customers for three years of premiums up front, how safe would you feel in their ability to repay you if your house burned down?