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Selgin on the history of 100% reserve banks

George Selgin is well known for having conducted detailed empirical work on the history and emergence of free banking. Most of his contributions have been in demonstrating the viability and ubiquity of fractionally reserved “free banks”, but in a recent blog post he is making another claim:

every significant 100-percent bank known to history was a government-sponsored enterprise, which depended for its existence on some combination of direct government subsidies, compulsory patronage, or laws suppressing rival (fractional reserve) institutions

Well worth a read.

23 comments to Selgin on the history of 100% reserve banks

  • Tom E. Snyder

    Fractional reserve banking is fraud. Obviously fraudulent banks will drive out legitimate banks.

  • Toby Baxendale

    AJE, thank you for drawing this post and comments to our readers attention.

    I wish this blog well in its desire to promote debate concerning free banking.

    Looking back into history via the lens of a 21st Century Economist / Historian, is always a difficult task.

    What business did not have royal/state/kin patronage to exist up until at least the 19th Century? Universities had Royal Charters to exist, towns had Royal Proclomations to allow them to hold a market in the town. State privilege was the norm. There is nothing new in this revelation .

    Today a FR bank can record is current creditors just as creditors. No other business on the planet can do this. They can use their current creditor money as theirs to enrich themsleves , no other business on the planet can do this.

    I have shown on this blog a custody bank with $25 trillion of dollors of custody accounts. I am told this bank is not a bank. There are a number of these, if you have a pension, your cash probably resides there. There are full reserve banks in Switzerland that bank over night in the Swiss Central Bank and maturity match term deposits very well. These exist despite the riggged nature of the system described above.

    The only question people involved in this debate should be advancing is what sort of banking do we want going forward?

    Martin Wolf in the FT today can see a very uncertain future for the Euro with it possibly having to be replaced, with existing bank liabilities in Euro being replaced with somthing else. This is radical talk from a very mainstream respectable journalist. The Reckoning of the whole system is heading fast towards us – a mother of all car crashes is unfolding before our eyes.

    Pete Boettke will always point out, private debt , nationalised to public debt = State default. Currency and banking runs writ large. Even the FT is now seeing this as a reality . Even Keynesian types see this as a possibility.

    With a unique moment in history unfolding before us, are all the free banking types, be they 100% reserve or fractional reserve going to say something unitied, purposeful and positive for our political masters to get a hold of and consider as a positive program for reform?

    Selgin and Huerta De Soto are the leading advocates of free banking. They Tower intellectually above the field.

    A Positive Program

    For sure, in the common law jurisdiction of the UK, a bank does not make you aware you are making a loan to it when you deposit. A bank tells you your money is safe, it does not make you aware your money is being loaned out. Contract law on bank contracts should be enforced and the Carswell Baker Bill adopted so people can lend / safe keep and transact – what more do you want from a bank. They should be like utility companies! Bring back boring banking.

    Cash balances held by people as a precaution should not be lent out as it curently is, clearly without their knowledge. Under FRFB this is a unstable part of the system be it free or unfree as people do not want these savings to go to loanable funds which they will do under the theory of free banking.

    All demand deposits swapped for physical cash. The cash now being owned by the depositor, the bank being the custody. This is not inflationary and people can then choose , do they want it kept safe or their momney lent out?

    The large increase in the net worth of the banks by this one off act can then be used creatively to pay off some of the massive tax payer liabilities we have. See Chapter 9 of Huerta De Soto’s 1998 book for more detail.

    Then, I think we have the foundations of a stable system from which to build a better future.

    Allow fracttional reserve accounts to those who want to have them. Allow the market to discover what bank liabilities people will or will not accept as money. Let the discovery process embark from solid foundations built on good contract law and solid property rights.

    In an acknowledgement that this practise is a pooling of your property rights and a more risky activity than custody and transactional banking,I would revert to the old common law understanding, that no gambling contract should be enforcable. Tony Blair in his efforts to build Super Casinos caved into the gaming lobby and derivative lobby to make gaming contracts enforcable in law. This was a backward move. This reverting to the wisdom of the past, would ensure no bank runs are possible as the FR contract would not be enforcable in a court of law. This would ensure that the mass hoards of innocent taxpayers will not have to come to the rescue of this system.

    Banks would be truly free and the market will decide what does and does not work.

    • Current

      What business did not have royal/state/kin patronage to exist up until at least the 19th Century? Universities had Royal Charters to exist, towns had Royal Proclomations to allow them to hold a market in the town. State privilege was the norm. There is nothing new in this revelation .

      That’s certainly true for companies. After the Bubble Act was passed in 1720 a Royal Charter was needed to start a limited liability company. It’s not true though for sole traders and partnerships. Many businesses in the 18th and 19th century were partnerships and sole traders, and certainly many banks were.

      Today a FR bank can record is current creditors just as creditors. No other business on the planet can do this.

      Well, we’ve discussed this many time before. Banks are not really so special. Rather than rehash what I’ve said before I’ll just link to it, so anyone who’s interested in the older arguments here can read it.
      http://www.cobdencentre.org/2011/05/the-importance-of-debate-on-banking-freedom/comment-page-1/#comment-28694

      Contract law on bank contracts should be enforced and the Carswell Baker Bill adopted so people can lend / safe keep and transact – what more do you want from a bank. They should be like utility companies! Bring back boring banking.

      Whether they should be like utility companies or not is a matter for their customers and shareholders. A lot of people today are saying that they want banks to “return to their core business”. Perhaps that would happen if deposit insurance were removed because customers wouldn’t tolerate the risk that speculation and derivatives trading would bring.

      I’m doubtful about this though…. Since the financial crisis began the left have been trying to associate it closely with the speculative activities of banks. CDOs and CLOs are certainly associated with that. But, they are in many ways a traditional business of banks – lending money to homebuyers – in a new form. The significance of that form of debt is that accounting regulations allowed them to be treated as a higher-quality type of debt. What we should remember is that there was still a collapse in the mortgage industry in Britain and Ireland, where collateralization was uncommon. RBS and HBOS became bankrupt through normal banking business – lending to businesses and individuals. They were exposed to some CDS and CDO contracts from the US housing bust, but as I understand it they bled the most from their domestic business. The of the large British commercial banks the one that engages the most in speculation – Barclays – came out the best. The same can be said of Ireland; Allied Irish Bank, AIB and BoI were made bankrupt by commercial lending in Ireland.

      All of this adds strength to the ABCT theory that easy money policies caused bubble, not changes in the banking industry.

      Under FRFB this is a unstable part of the system be it free or unfree as people do not want these savings to go to loanable funds which they will do under the theory of free banking.

      I don’t think you can speak for others. Perhaps you don’t want your current account balance to contribute to loanable funds, I however certainly do.

      n an acknowledgement that this practise is a pooling of your property rights and a more risky activity than custody and transactional banking,I would revert to the old common law understanding, that no gambling contract should be enforcable. Tony Blair in his efforts to build Super Casinos caved into the gaming lobby and derivative lobby to make gaming contracts enforcable in law. This was a backward move.

      Gambling contracts were made enforcable by law a long time before Tony Blair and his supercasinos came along.

      To understand the old law we must consider: What is gambling and what is investment or speculation? Traditionally gambling is a zero-sum or negative-sum venture. What one person wins another loses. The prediction of the game may involve judgement or just simple luck, but whichever it is gambling is zero-sum or negative-sum. Investment or entrepreneurship is different. In that case there is the possibility of overall welfare enhancement. The purchasers of a product may value it more highly than the price they pay for it, a price which includes a profit for the investor.

      No anti-gambling law is intended to punish people for taking risks. If that were the case the entrepreneurship would be impossible. Toby, imagine what it would have been like when founding your business if the government had said “he’s taking a risk here, so any contracts he makes aren’t enforcable by law”. I think that would have made this much more difficult. Now, fractional-reserve banking fits into the same category as Toby’s business or any business. It’s not a zero-sum game, it’s entrepreneurship. The bank supplies services to it’s customers and possibly interest, in return the customers supply loanable funds. If the customer considers their return from the services and interest to be greater than the cost of the extra-risk they take by lending their money then the service is valuable to them. So, since banking is in this sense a normal business there is no reason for it to be excluded from protection by the law.

      • Toby Baxendale

        Current, you write well for most of your posts on this site, you then deliver up a googly!

        The 1845 Gaming Act made all gambling contracts UNENFORCABLE, PERIOD. The Great Blair reveresed this in the Gambling Act 2005.

        The derivatives lobby lobbied extensively for this as did the Casinos. I would bet with you myself that 99.9% of all financial derivitives have no underlying “real” thing and are justs bets on bets, hence their interest is making their work not fall foul of the 1845 Gaming Act.

        How we could let a bet – as CDO (put some good mortages with a lot of crap and get some wonky credit agency to say the good is the prime part of the book) then and bet on a bet (CDO squared, there will never be default – upward only house prices – yipeeeee!) be a “security” is positively mad.

        They went bust because they were fractional, betting like an gambing adict and oh, by the way, they mad a few poor business loans, bought a bank at the top of the boom, the latter being small in comparison to the former indiscretions.

        Also , in booking these bets, they took large parts of the future expected returns , not realised in cash for up to 30 years, into their current years P&L and paid out CASH, yes CASH bonuses when there is no realised cash to pay any bonuses. Where does this cash get taken from? The deposit base. Oh how lovely, all those people who think their money is being either kept safe of lent to business and first time buyers. Those foolish stupid people hey.

        Your want to defend fractional reserve free banking and money equilibrium theory should not cause you to ignore cold , hard facts.

        I think Gordon Kerr at Cobden Partners could well tell you whay RBS went belly up.

        • Anthony J. Evans aje

          Toby – you should raise some of these issues with Ed Stringham whilst he’s in London. He’s done a lot of work on why limiting analysis to pieces of legislation is a bad idea.

          e.g. http://ssrn.com/abstract=1676251

        • mrg

          Toby, are you suggesting that the 1845 Gaming Act was right to make all gambling contracts unenforceable, and that Blair was wrong to liberalise in this area?

          I expect most Cobden Centre readers are with me when I say that consenting adults should be free to enter into gambling contracts, and that these should be treated no differently from other contracts. As long as there’s no fraud involved, the State has neither duty nor right to intervene.

          Have I misunderstood you?

          • MRG, the quick answer is that from the Dawn of Man in the common law countries , courts would never enforce arrangements that were not contracts otherwise they would be involved in all sorts of rubbish, so the bar is set that to have a contract, you must have a bargain to enforce. This bargain is evidenced by consideration . Consideration is getting something for it. Not having consideration it is not a contract with purpose . A man offers you a £1m for your house , you have words that are unenforceable . A man offers you £1m and pays a 10% deposit we have the parties clear intention and consideration evidenced . The former is puff the latter is enforceable .

            A bet of one outcome v another is something that the courts do not get involved with as this does not further commerce , wealth creation or the peaceful trade of the nation or the civil association .

            Bets should not be a matter of the courts . The collective wisdom of 2000 years should not have been cast aside by rash legislation .

        • Current

          The derivatives lobby lobbied extensively for this as did the Casinos. I would bet with you myself that 99.9% of all financial derivitives have no underlying “real” thing and are justs bets on bets, hence their interest is making their work not fall foul of the 1845 Gaming Act.

          How we could let a bet – as CDO (put some good mortages with a lot of crap and get some wonky credit agency to say the good is the prime part of the book) then and bet on a bet (CDO squared, there will never be default – upward only house prices – yipeeeee!) be a “security” is positively mad.

          A CDO isn’t like a bet, it is essentially a bond that pay interest made up of other interest paying bonds. A CDO squared is a collection of CDOs. If the 1845 Gaming act you mention were in force I fail to see how it would make any of this illegal. A bond of any sort is different from a bet. A bond isn’t a zero sum game because the borrowers must pay back with interest. Bonds certainly were protected by law in the 19th century. It quite true that in the crisis the default rates for CDOs became much higher than the banks thought that they would be (and they still are), but that doesn’t mean that the banks were gambling. Rather they were taking an entrepreneurial risk, one which at least from the point-of-view of their shareholders they misjudged. You can say that this entrepreneurial judgement was “mad”, and there’s certainly an argument for that. However, it’s not something that can be banned by gambling laws without banning any other form of entrepreneurship.

          Some forms of derivative are closer to gambling. Spread betting on shares isn’t normally considered a derivative. It can be classed as gambling. Spread betting contracts have the force of law though, at least since the Financial Services and Markets Act 2000.

          It could be argued that futures and options are gambling because for every “put” there is a corresponding “call”. So, at the execution of the trade one of the two parties will be poorer by the amount the other is richer. But, this ignores internal rates of return (I mentioned this in a recent post). The seller of an option my rationally accept a lower price for something he can supply in the future because he can buy something useful with the money and invest it. The classical example of this is the American farmer who sells his crops before he has harvested them on the Chicago merchantile exchange and then invests the money in new equipment for next years crop.

          Futures and options have been traded in London for centuries. The London Metal Exchange has traded futures and options in metals since 1877. Before it existed that trade was done in the Royal Exchange. (There were futures and options in other things, those markets became amalgamated in the LIFFE exchange and then that became Euronext.) It may be that this wasn’t protected by law, but I doubt that considering the size of the market. I’m not a lawyer, but I think the right-of-first refusal makes options contracts protected by law.

          Also, although this is a sidenote, as far as I understand it gambling was protected by law before Blair.

          They went bust because they were fractional,

          Whenever banks fail because of bad debts Rothbardians seem to claim that they have failed because their “fractional”. But, a bank that only offers timed savings can make bad debts too. Is the theory that banks that maturity match are more wholesome and so grant more wholesome loans? I agree that if current account holders had used 100% reserve banking then they would have been safe, but that’s not quite the point. Any bank can make bad debts no matter where it’s funding comes from. A connection can only be established between bad debts and fractional reserves if either:
          1) A macroeconomic connection between FRB and unsustainable booms can be shown. ABCT doesn’t give one anything like as clearly as many people think.
          2) Current account holders decide to run on a solvent bank. If this happens then the bank is bankrupted by it’s FRB funding drying up, not by it’s loan book. This has happened, but examples of it are rare.

          betting like an gambing adict and oh, by the way, they mad a few poor business loans, bought a bank at the top of the boom, the latter being small in comparison to the former indiscretions.

          Do you mean RBS here or RBS & HBOS? You may be right about that for RBS at least. I’ve heard both stories regarding RBS, some say it was normal lending some say it was CDOs from the US. Anyway, I defer to Gordon Kerr’s understanding of this.

          I’ll comment on Gordon Kerr’s post regarding everything else.

          • Yes you are right Current , a CDO is not a bet like a option or swap contract when you are just saving “if outcome a you get £x if outcome b I get £x.” The product is the underlying mortgage repayments . A CDO squared or any synthetic product is a bet on this outcome against someone else bet. The former is not gambling the latter is gambling . One contract should be enforceable as there is a clear intention to do something real and is transactional , wealth creating , commercial with real intentions of bargain between the parties . The other is just a shuffling of paper claims from one party to the other without and net increase in wealth at all, it is a zero sum game unless you are the banker . See Gordon Kerr’s comments .

            Frivolous activities between consenting adults are totally fine and great , but the public should not be burdened with having to pay for one sides solvency when the bet goes the other way. Nor should courts which we pay for be burdened this way.

            I use the word bet for CDO’s to say they were nets as the lack of fiduciary care the bankers took with their clients money placed on a fiduciary basis , is sandelous .

            Those who support FRFB, seem to be oblivious to what actually constitutes a contract , what should be part of banking and what should not and also what is the relationship between the banker and the client.

            • Current

              A CDO squared or any synthetic product is a bet on this outcome against someone else bet.

              If that’s what you mean then I agree with you. It depends on the definition of “CDO squared” though, a CDO of CDOs is still a bond. A bet on prices of CDOs is a bet.

              I think you’re mixing up synthetic CDOs with CDO^2s. A bet on CDOs using CDSes is a synthetic CDO, a CDO^2 is a bond or vehicle made up of CDOs.

              Nor should courts which we pay for be burdened this way.

              No, but what about courts we don’t pay for? The argument that gambling shouldn’t be legally actionable falls down because of the existence of civil courts. Why shouldn’t contract breaches between gambling participants be considered a civil matter and the law setup so that court costs are paid for by the losing party.

              I use the word bet for CDO’s to say they were nets as the lack of fiduciary care the bankers took with their clients money placed on a fiduciary basis , is sandelous.

              I don’t see how this follows at all. A banker is by nature an entrepreneur and that inevitably involves risks. Even a 100% reserve bank involves risks – such as being robbed. You can’t justify saying to bankers that they must take no risk or very minimal risk while allowing other entrepreneurs to take risk.

              Those who support FRFB, seem to be oblivious to what actually constitutes a contract , what should be part of banking and what should not and also what is the relationship between the banker and the client.

              I’m far from “oblivious”, I’ve discussed these things with you many times before.

              You have a very certain idea about what banking should be. That’s reasonable as far as your own choices of banking services go, but it has nothing to do with what others do. You may want it to be a fiduciary relationship that prevents the banker from lending out money, that’s fine, but it should not bind anyone else.

              You can only make a case for binding other people if you can show that FRFB has negative social consequences such as recessions. I think you’ll have problems demonstrating that. And you can make a case for misrepresentation if that is occurring. I think you have a bit of a case there, banks could declare more clearly than they deal in debt.

              But, in my view that’s all you can do within a libertarian agenda. You can’t arbitrarily declare that banks are “gambling” when they’re simply taking risks like other entrepreneurs. Nor can you declare that the relationship between the banker and the customer must be “fiduciary” in any particular sense, that’s a matter for those two parties.

              I think that this campaign for banks to be “utilities” is illiberal. Whether something becomes a utility or not is a question of what the market accepts through market processes. If the government declares something a utility by fiat then that’s just a limitation on the market. In my opinion banking is naturally entrepreneurial since it involves the bank taking risks on new businesses, I don’t think it will ever become a utility.

              • Law of Contract: Look up what makes a contract binding. See the word “consideration,” this shows intent on the parties and something of substance is exchanged to make the contract not puff, but binding. Where is this in a gambling contract?

                You are so mistaken. I have never said I do not want banks to lend, I want them to lend when ever they have a good business etc to lend to and when they have money that their client base wants them to lend to. This is the heart of banking and the fiduciary relationship of a banker. Not to lend if the client does not want their money lent and only to business and people that they have judiciously researched and are ahppy with as an appropriate risk. I cant see how anyone can not say that is reasonable.

                You are so off the mark on many points, I do wonder why you comment sometimes on this site.

              • Current

                See the word “consideration,” this shows intent on the parties and something of substance is exchanged to make the contract not puff, but binding. Where is this in a gambling contract?

                I don’t see how gambling fails this test. If I bet Tony $10 that a particular horse will win a race then isn’t the consideration the winnings – if there are any?

                I have never said I do not want banks to lend

                And I haven’t said that you don’t. When I said “You may want it to be a fiduciary relationship that prevents the banker from lending out money, that’s fine, but it should not bind anyone else.” I was referring to your earlier post here:
                http://www.cobdencentre.org/2011/04/remember-real-bankers-are-fiduciaries/
                Where you associated a fiduciary relationship with 100% reserves. The problem with that, as I pointed out at the time, is that the exact relationship between a customer and banker is defined by those involved. Even under your proposal to make gambling unenforcable this wouldn’t affect this relationship even if fractional-reserves were used, because it would remain an entrepreneurial one.

                If you merely want to make unenforcable by law the two things we have mentioned (synthetic CDOs and CDS’s that aren’t insurance), then you won’t get much complaint from me. Though I don’t really agree with making them unenforcable, it’s not a very important point in my opinion. But towards the beginning of this thread your aim seemed to be to more generally in the direction of new forms of financial contract. You wrote:

                In an acknowledgement that this practise is a pooling of your property rights and a more risky activity than custody and transactional banking, I would revert to the old common law understanding, that no gambling contract should be enforcable.

                Here you are associating one thing being more risky than another with “gambling”. For the reasons I have already described it isn’t the same thing.

                You could perhaps argue that if a bank is involved in CDS gambling then it’s current account holders should not be protected by law. But, that doesn’t apply to all “pooling of property rights”, it doesn’t apply to fractional reserves in general only (at most) to FR banks that indulge in such gambling. (It doesn’t apply to shareholding either, though I don’t think you were criticising that).

                You are so off the mark on many points, I do wonder why you comment sometimes on this site.

                My post was grumpy, so it deserved a grumpy answer.

                I don’t post on this site because I think I will persuade you :). I post because many other people sites like this who haven’t made up their mind.

              • Something must pass from a to b for there to be enforcable consideration. I saying to you, “I will give you all my worldy wealth if you respond to this in the next 5 mins” is puff, there is no consideration. If I then set out my position and supplied something of substance for you to take me seriously, then we start to move towards a contract that a law court will enforce. Off the top of my head, they will need to establish “is there a meeting of the minds.” Do both parties have capacity ? Are they mental etc and so on and so forth. There are more.

                A bet is not a contract in contracrt law as there is no consideration . Since 2007 it is no enforced by Statute Law.

        • Chris Cresci

          Doesn’t gambling require the outcome to be completely random? If that is the case then CDOs while being “bets” in the sense that they are a wager about outcomes are not “gambling” proper in that the outcomes are not aleatory.

          • mrg

            “Doesn’t gambling require the outcome to be completely random?”

            The outcome in poker isn’t completely random, but most people would consider it gambling.

            In any case, I think this whole gambling discussion is a red herring, since it rests on the assumption that gambling should be treated specially by the law.

            Since we don’t all agree that gambling is Evil, Bad, and Wrong, and in need of special treatment, I don’t think the analogy gets us very far.

  • George Selgin

    Tell me, Mr. Snyder: do you also think it “obvious” that fraudulent firms generally drive out legitimate ones? And do you think that, within fractional-reserve banking systems, the most fraudulent banks must “obviously” driven out the less fraudulent ones? Finally, since fraud necessarily requires misrepresentation of some kind, may I presume that you consider yourself among the few persons who are enlightened enough to have figured out what the banks have been up to, while supposing that most other persons remain naive dupes? Or do you propose that people, perhaps including yourself (if you hold a bank account) knowlingly allow themselves, or have allowed themselves in the past, to be systematically defrauded?

    I hope you will endulge me with your answers, as I am planning to write my next post on “How 100 Percent Reserve Advocates Think.”

  • Running the line that FRB is fraud is a hard one.

    Fraud is one of the most extreme of all crimes / civil wrongs . You have to prove a wilful , purposeful series of actions have taken place to deprive someone of their rightful property .

    Is this banking? I think not.

    I think you could run an argument of negligent misrepresentation in contract law , not tort or criminal on the grounds that the banker who takes your deposit is not clear with what he / she and or the bank is going to do with it. Indeed , both parties seem very confused . As I repetitively say on this site and others , now in my third decade of business, when I have made a commercial or a personal fiduciary deposit , I have never been made aware that I am making a loan. I have always been told my money is safe. Do I believe a fraud has taken place , no. Do I think lack of clarity / confusion , yes. Have I been deprived of any of my property , so far no. As a taxpayer , yes i am out of pocket . No grounds for a charge of fraud , but a claim of restitution on behalf of the taxpayer may well be a way forward for all the money used to bail out the current state sanctioned FR system. Then having said that , any payout would only come from the taxpayer , so not worth it . It is sloppy to run an argument of fraud and doomed to failure . Negligent mis rep at best . Confusion or just the cock up theory more than likely .

  • To Selgin’s original quotation, I say, “so what?”.

    And I look forward to his essay on how full-reserve advocates think, being one of them myself.

    I see the presently unfolding debate being one between free-banking advocates and public money advocates, and not as between the fractionally-reserved versus fully-reserved free banking advocates.

    That’s a fine debate for you all to have.

    Ultimately, to my way of thinking, only full-reserve banking can restore stability to the money system and a semblance of same to national economies.

    As for how some group of full-reserve advocates think, I suggest a listen to this link, it’s a little stilted at the very beginning, being the Douglas, Fisher, Graham edition from 1939. Worth a listen.

    http://k002.kiwi6.com/hotlink/169p578y94/A_PROGRAM_FOR_MONETARY_REFORMb.mp3

    Thanks.

  • James Turk

    I wrote to George noting that he didn’t mention the Bank of Hamburg. Here is what I wrote to him in part:

    “For around 250 years [the Bank of Hamburg] was a true ‘bank of commerce’ (i.e., payments only and no lending). The Bank of Hamburg was controlled by merchants of the Hanseatic League, who carefully guarded its operation. Its unit of account was the Mark Banco, which was a weight of silver.

    The Bank of Hamburg survived Napoleon’s invasion, who was said to be incredulous when he found the reserve of silver was 102% of deposits. However, it did not survive Bismarck.

    The Mark Banco ended in 1871 only because Bismarck recognized that a super-State required control of the currency. As a consequence, he created the Reichsmark, which purposefully included “mark” in its name to give his new currency credibility, given the high regard in which the Mark Banco was held.

    Clearly, the Bank of Hamburg survived long past the demise of the Bank of Amsterdam. And it didn’t require special subsidies or privileges from the state.”

  • Toby Baxendale kindly invites me to comment on the reasons why the banks failed in 07 and 08, in his response to Current above (June 1st at 22.04).

    Banks’ future failure was obvious to me given the absurd regulatory and accounting rule framework that had been put in place by the mid noughties. They are certain to fail again, since subsequent rules have made the position, and the economic drivers for bankers, even worse for the taxpayer.

    Economics is all about incentives and human behaviour. Banker compensation is linked to accounting profit. If rules are created by incompetent regulators and accounting bodies that enable bankers legitimately to account for the vast bulk of cash under their stewardship as profit today in the virtual certainty that the bank will fail tomorrow, guess what will happen.

    http://www.cobdencentre.org/2011/03/the-banking-crisis-has-been-exacerbated-by-new-rules-and-regulations/

    CDOs etc did not represent traditional lending activity. At the consumer level CDOs worked so well for banker compensation that they incentivised the creation of loans to very weak borrowers purely to drive the CDO engine (sub-prime).

    At the corporate level they encouraged loan recycling, not new loans. By 2006 a great percentage of newly issued Eurobonds never reached “end investors”. They were bought by the IB market, packaged together and reissued. Rating Agencies wrongly concluded that default risks were lowered (ie ratings raised) if chunks of bonds from different industries were bundled (non-correlation).

    The bank systemic failure exposed the lunacy of this non-correlation theory. The agencies have downgraded by 5 notches (ie from AAA to say B) up to 4500 CDO transactions.

    The only motive for the rise of the credit default swap market and its spawn, synthetic CDOs, was banker compensation. Current is wrong to suggest this is a modern form of bank lending.

    Securitising either in cash or, even better synthetically (via derivatives, ie not tested by the need for a cash market transaction) enables banks to front end profits; I would say falsify profits.

    When its credit default swap liabilities had brought AIG into trouble, AIG was negotiating with its CDS counterparties to accept 60 cents on the dollar. Amazingly the failed creditor banks were better poker players than the guardians of US taxpayer funds and the banks won a 100% TARP bailout, or $62billion in respect of these AIG swaps. (See Johnson and Kwak “Thirteen Bankers” pp 169, 170).

    RBS is mentioned above. That bank appears to me to be pushing the accounting rules beyond any measure of acceptability. UK taxpayers insure its junk portfolio and Her Majesty’s Treasury valued (mid 2010) the expected losses at £25bn higher than RBS employees, and I await a reply to my May 31st letter as reported in the Daily Telegraph on June 2nd:

    http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/8551272/Royal-Bank-of-Scotland-told-by-MPs-to-explain-25bn-accounting-distortion.html

    • Current

      Gordon,

      Recently Anthony Evans has shared his thoughts on this with me. He doesn’t really agree with you that incentives are so paramount.

      The argument that follows on from my reply to Toby’s earlier post is a bit more specific though. What I intended to say is that bank failures have not being tied tightly to use of CDOs, and CDOs aren’t as unusual as some claim.

      What I mean when I say that CDOs are not that different to traditional lending is this… A CDO is a bond constructed from a package of mortgages. Securitization of debt in this way has gone on for many decades (at least, I think centuries). The bank is still borrowing from savers and investors and lending to home-owners. Though the precise form is different. It may be as you say that this particular form and the regulatory structure around modern banking accounts incentivizes the management of banks to behave is particular ways. But, I think that’s different from saying that it’s not a “traditional” banking activity.

      As Toby says above, betting on the direction that assets will move indirectly certainly is “non-traditional” and very similar to betting at a bookies. To some extent CDS are like selling or buying insurance. But, that depends on whether the institution involved has a position in the market. That is, if I bet on my house catching fire then I’m buying insurance, but if I bet on your house catching fire then I’m gambling.

      I’m not convinced about the close tie between failures and CDOs either. The failure of the three largest irish banks is a good example of this. AIB, BOI, and Anglo-Irish had little or no exposure to collateralised bonds. They failed by making bad loans on commercial property and housing (mostly on commercial property). That said it’s hard to tell how much of their failure resulted from contagion from the US crisis. My point about RBS was that it’s difficult to tell if it’s failure was due to it’s CDO portfolio from the US, I’ve read some commentators saying that it was mark-downs in it’s domestic lending business that were the greater cause. I wasn’t talking about it’s recent behaviour. Maybe you could shed some light on that? In my opinion, while interest rates were low and the boom phase of ABCT was in progress very many banks became over-extended regardless of whether they used CDOs or not.

      I’m not convinced either that “non-correlation” is “lunacy”. The question here is: did loans that were de-correlated perform better than those that weren’t. I expect both sorts performed badly since the crisis. I expect that in retrospect both were given ratings that were too high by the ratings agencies.

      Lastly, I’m not really so convinced that the accounting practices you criticise necessarily lead to certain failure. Surely bank directors, as much as anyone else care about their future earnings. Even if we accept they care nothing about their reputations per se surely they do care about their future career in that field. For it to be worthwhile for a bank director to misrepresent his accounts in order to gain a larger bonus the size of that extra bonus payment must be enough to compensate his for future income foregone. Secondly, shareholders have a strong incentive to prevent this kind of misbehaviour. It may be the case that they were blocked from knowing about it by insider trading laws. If that is the case then it’s more an argument against insider trading laws than one for changing accountancy standards. That said, I’m sceptical about the practical effectiveness of insider trading laws. I think institutional investors know about things like this even if legally speaking they should not. This leads me to think that institutional investors must have been confident that this financial representation was to their interest.

      I don’t see anything very wrong with your campaign to make banks account under GAAP rules as well as IFRS, but I’m not convinced it will make any difference in the future.

      • Gordon Kerr

        Dear Current,

        You make many points which I’m sure would seem sensible to an intelligent lay commentator (ie non-banker). Unfortunately banking is in chaos now owing to the extreme drive for up front profit and, yes, the effect of incentives in the form of poorly drafted rules and the consequential behavious of bankers.

        I would comment on your two main points:

        a) you say CDOs etc are not too great a problem because some Irish banks failed without much CDO exposure. This is a non-sequitur. At no stage did I suggest that unless a bank bought CDOs it would be safe and sound.

        My comment about CDOs was intended to show regulatory capture at its peak. There is no doubt that CDOs were some of the most egregious examples of rule gaming and left most owners deeply out of pocket. Rating agencies have downgraded nearly 5000 CDO transactions by up to 5 notches – from AAA to B. Why? Because CDOs incorporated both i) rating errors (non-correlation was indeed lunacy – the multiple assets in CDOs proved to be highly correlated in the crash) and ii) accounting errors; IFRS accounting enabled assets (esp synthetic assets) to go in to CDOs at MTM values, not lower of historic cost and MTM.

        b) You suggest that I overstate how bad things are on the ground that surely senior bankers would step in and stop this nonsense to protect their own reputations. I disagree with your interpretation of incentives. Nothing gets in the way of profit, albeit fake profit! See Lord Lawson:
        http://bankingcommission.independent.gov.uk/wp-content/uploads/2011/01/Nigel-Lawson-Issues-Paper-Response.pdf

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