Why Banks are out of Control

I just had an interesting comment debate with my buddy Matt over at the Online Investing AI Blog.  Matt’s a big fan of derivatives and a laissez-faire kind of guy.  He views government regulation with a heavy dose of skepticism.  I am not a big fan of cumbersome regulation myself.  But, I have become firmly convinced the banking industry is out of control and they need to be more effectively governed.

Our economy, industry, currency, investments and the very future of our nation depend on the stability of our markets and financial systems.  In the past decade, we have allowed banks to gamble with our future to increase their profits and this turned into a disaster.  Banks have shown no remorse for the financial crisis they created and they remain defiant in the face of reform. If left unchecked, the potential for disaster will only increase.  

The Seeds of Failure

Image by The Consumerist

Image by The Consumerist

The Glass-Steagall Act was created after the Great Depression to protect depositors from risky bank speculation.  And, it worked very well for over sixty years.  However, it was quietly dismantled in 1999 in a bi-partisan effort signed by President Clinton and lobbied for by the banking industry.  Many economists now agree this key piece of legislation could have prevented the Sub-prime Crisis of 2008.  

The reason Glass-Steagall was so crucial and the reason it should be restored, is because it mandated the separation of deposit and investment banks.  The repeal means a number of scary things.  Most important, deposit banks can now trade in risky derivatives with your money and if they go under, the FDIC must pay the depositors.  This places the total risk of speculation on everyone but the bank.  Also, bank holding companies can now be formed with the rights of both deposit and investment banks.  Many investment banks quickly reformed as holding companies to grab a share of the TARP money, even though deposits and lending wasn’t their primary business. 

The Bailout Mentality

Our government has set a dangerous precedent of bailing out banks, which in my opinion, encourages them to take unwarranted risks.  This started with the Savings and Loan Crisis of the ’80s and continued with RTC crisis of the ’90s.  During the Sub-prime Crisis of 2008, the financial industry received almost a trillion dollars of taxpayer money, in addition to an unknown amount received from the Fed for lending.  And, the foreclosures are far from over.

Banks will continue to speculate wildly and then expect a bailout, as long as the government is willing to shift the burden onto taxpayers.  It’s no different than if you visited a casino and you got to keep your winnings, but they refunded your losses.  Of course, you would gamble as much as possible.  Especially, if you received huge bonuses win or lose.  That’s what has been happening in America and it has to stop.

Derivatives Reform

There is a huge reason we need derivatives reform.  As I have posted before, the notional amount of derivatives volume is approximately 11 times the combined GDP of all the nations in the world.  This is an insane risk to let bankers, hedge funds and insurance companies gamble for profits with so much leverage.  The potential for disaster is overwhelming and the next financial crisis is inevitable.

There are many forms of derivatives that should have never been legal in the first place.  Securities with unlimited loss potential, such as naked shorts, should be banned.  Securities without underlying assets, such as synthetic CDOs, should be banned.  And, securities should be limited to a leverage multiple that is reasonable, such as 10-1.  Purchasers should be required to prove they can cover their positions, so we don’t have any more defaults like AIG and LTCM.  Finally, all derivatives should be traded on a regulated exchange, so they can be monitored by the SEC.

The Bottom Line

The bottom line is that I’m not opposed to bankers making a profit.  And, they have plenty of opportunities, without gambling with our economy.  Unless we limit their reckless activities, taxpayers will continue to pay the price in lost jobs and growing deficits.

“We need smart regulation. But we have a stupid government.”

Matt – Online Investing AI blog

Recommended Reading

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10 comments to Why Banks are out of Control

  • I’m not really conviced that regulation is the answer. I think alowing banks to collapse and having informend consumers of financial products is the answer. By having strong regulation (for anything) it leads to an environment where responsibility is externalised. Every time something goes wrong it’s someone elses fault. I run into this problem where many of the people I counsel feel it was THE BANKS fault they’re in debt. They shouldn’t have lent me so much. In my head i’m thinking no one put a gun to your head and made you sign the loan contract. You should have decided if it was affordable!

    The banks, the auto companies should have been left to fail. That’s what recessions are ment to do sort the wheat from the chaff.

    The international ecconomy is large and complex and everytime you regulate you cause unexpected consequences. In australia the government guranteed banks savings which lead to the collapse of many managed investments because investors fled to safety of the banks.

    You can’t regulate out risk, it’s a requirement of life
    Benjamin Bankruptcy recently posted..Budgeting apparently I need to do it-My Profile

    • Benjamin,

      The Financial Regulatory Reform bill will probably be signed into law today. So, the U.S. will see how effective these regulations are in controlling these problems.

      I used to be a huge believer in free markets and an opponent of government intervention. But, a free market only works when it is truly open and competitive. With all of the leverage and manipulation, the financial markets are not being driven purely by trading. And, with all of the consolidation and political clout, business is not being driven by competetive pressures.

      I also believe consumers should have fundamental rights and protections. Over the past couple of decades, consumer protections have virtually disappeared, to the point where companies are preying on consumers. There is an endless list of things that should have been illegal, including universal default, double-cycle billing, 10 AM cutoffs, reordering overdrafts, etc. This doesn’t excuse the stupidity of the consumer or protect them from themselves, it’s just basic fairness.

      • I see that the Financial Reform Bill passed. So only time will tell.

        I get irritated by the public conversation at the moment about “the failure of the free market”. I’m not sure if there’s one ACTUAL free market on the planet.

        I think further reform doesn’t address the problem. If businesses failed if investors lost their money if employees lost their jobs and their house. Maybe everyone would pay a bit more attention.

        In Australia business has no political clout at all much to the detriment of the country. The party currently in power was formed by unions at the turn of the last century. This had led to alot of positive things like universal healthcare and pensions, free education. But it’s also created an environment where out of a population of 22million only 6.5 mil work AT ALL!

        We have 4 banks with 95% of the banking market, last time I checked there were well over 100 banks in the states?
        Benjamin Bankruptcy recently posted..Budget EvaluationMy Profile

  • I’ve written a lot about this problem in my newsletter. I agree that Glass-Steagall needs to come back. Banks have so much political power (look at how many Goldman Sachs people that are high in the US government) that they can privatize profits and socialize risks. The “too big to fail” have not been broken up. On the contrary, they’ve been allowed to get bigger! I think the long-term solution is to break banks into small parts and let the dumb ones fail. That way there won’t be any “systemic risk” argument.

    I also agree 100% that derivatives need to be traded transparently. I’ve read that there are over $1 quadrillion in derivatives outstanding – many times more than the annual world GDP.
    Jennifer Barry recently posted..How to Take College Classes for FreeMy Profile

    • Jennifer,

      The Financial Regulatory Reform bill reinstates parts of Glass-Steagall, separates investment and commercial banks and allows the Fed to wind down failed institutions at shareholder expense, instead of sticking taxpayers. It also cracks down on derivatives trading. I am still analyzing this huge bill, but these are critical reforms.

      If your newsletter is online, please provide a link. I didn’t see these articles on your blog and I would love to read them.

  • Hi Bret, hopefully these sections STAY in the bill. Politicians tend to cut real reform out of bills or water them down before passage.

    Sorry for the confusion on the newsletter. I have some essays here: “A Silver Lining to US Corruption” deals with many of these themes.
    Jennifer Barry recently posted..Stranger in His Own Land- Part 2My Profile

    • Jennifer,

      I loved the article and I agree about the higest levels of corruption. I also read Matt Taibi’s piece in Rolling Stone and used to follow his blog when it was up. I am hoping the huge $550 million settlement by Goldman Sachs signifies that changes are finally coming. Thanks to people like Matt, these issues are finally out in the open.

  • Bret,
    You did a great job at this. I did want to add that my real fear–besides stupid regulations–is that financial innovation will be stifled.
    Perhaps derivative products failed, or more accurately, that people misused them. But, new risk management products and techniques must be allowed to be vetted.
    I’m all for transparency and letting the investor take rewards–and responsibility–for his or her trade.

    • Thanks Matt,

      I’m not so worried about the new financial regulations stifling innovation. Most of the details I am reading are pretty much common sense. Despite the backlash against banks for the financial crisis, none of the regulation seems burdensome or punitive. Of course, with the way our government is right now, some official could always abuse this law. But, that never happened with depression era legislation, like Glass-Steagall.

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