I’ve read on this site – largely in the comments section of financial-oriented diaries, and occasionally in a diary itself – lots of calls to let the ‘bad banks’ fail. While the attitude is understandable, and we can all agree there should be appropriate consequences for bank mismanagement, I wanted to spell out a few likely consequences of letting Citibank, Bank of America, and other banks on the edge of solvency simply go bust. It’s my hope that this will push some well-intentioned folks away from advocating a solution that’s not going to be taken seriously by any federal policymaker, and one that would inflict an unacceptable amount of damage on our national economy.
1 – Bye-bye, FDIC
Bank of America has approximately $850 billion in deposits. Citibank has approximately $750 billion.
The FDIC has assets of about $50 billion. Granted, not all of Citi and BofA's deposits are insured - but more than enough of them are to make the FDIC insolvent in short order.
So in the short-term, plan to take a week off work to stand in line waiting for your money with your fingers crossed. Long-term, say goodbye to a recovery during Obama’s first term, which, among other bad things, puts us at acute risk of a Republican resurgence in 2012.
Because if the US government sends the signal that they are willing to leave even insured depositors twisting in the wind, the flow of funds into the US will throw itself into reverse in short order, starving the country of the capital needed to make loans and other investments in economic growth. No one wants to put their money somewhere where it might just evaporate – and it will take the smaller players a long time & much infrastructure investment to be in a position to fill the void. That investment will be especially hard to make in a time when all available capital is going towards covering write-downs, and new capital is hard to come by.
And on top of it all, it would take at least another generation before the FDIC once again became solvent enough to stand behind the mission FDR endowed it with. If the mission of this site is to help Democrats win elections, then this alone should be enough to dispel the notion of bank failure as a viable alternative – it will relegate President Obama to the one-termer dustbin.
But it gets worse.
2 – Empty Shelves and Panic in the Streets
Even more distressing, if that’s possible, will be the negative impact of large bank failures on the physical flow of goods worldwide. Global trade is largely undergirded by Letters of Credit (LoCs). LoCs expedite trade by alleviating the need for a company to make an actual payment at every point in the world at which raw materials/work in process moves from one part of the supply chain to another. LoCs are posted by banks and essentially attest to the fact that the company in question is good for the payment. The reason LoCs are accepted and trusted by suppliers in lieu of actual payment is that the bank itself is on the hook if they have misrepresented the creditworthiness of the company.
You see where this is going: if a large segment of banks are allowed to fail, any LoC they have written, anywhere in the world, becomes a worthless piece of paper. The flow of goods grinds to a halt; ships will sit at ports for days, even weeks, instead of offloading their cargo and getting on to the next job; and companies in the US and elsewhere will find themselves unable to meet production schedules, unable to keep goods flowing out the door, and therefore unable to retain employees, leading to further layoffs and economic contraction.
The first wave of casualties will obviously be the companies relying on the failed banks for trade credit – but, again, the signal sent by the US Government, that they’re willing to stand by and watch a financial institution go down in flames, will quickly erode confidence in other LoCs posted by other banks. And though, over time, healthy institutions will step in to fill the void, there are a few things to keep in mind here:
a) LoCs aren’t commodities like gasoline or paper – each one is a beautiful, unique snowflake, customized to the particular industry, geography, and companies in question. Another institution can’t just step in and assume responsibility for a LoC; it will take lots of time and expense to fill the void created by bank failures.
b) The failure of large institutions will drastically reduce the capacity of the banking industry to provide LoCs in the medium-term. The impact on trade would more or less destroy hopes for an economic recovery by 2012 and, again, open the door for a Republican resurgence.
c)This is not the kind of thing the government can just step in and do – they don’t have the requisite experience or skill set to do this well, and the amount of capital it would take makes TARP look like the
National Helium Reserve. The potential for mass misappropriation of taxpayer funds is enormous.
d) You might find the long-term implication of further impediments to global trade appealing (to change your mind on that would go well beyond this diary) – but, channeling my inner Rumsfeld, this is the production system we do have, not the one we wish we had. The short- and medium-term implications of this kind of disruption would be severe shortages of actual physical goods across the country, creating a level of panic that we have fortunately avoided in the crisis to this point. And the brunt of the ensuing job losses would be borne by those who actually, you know, make stuff. Those are the kinds of jobs we should be trying to save and expand, not subjecting to further strain.
3 – Screw You, Working Class
Obviously the first two implications I’ve drawn out here would have a profoundly negative impact on household wealth and retirement savings. But even setting those aside, I want to specifically address the attitude that ‘shareholders deserve to pay’ for these banks’ management failures. The vast, vast, vast majority of shareholder wealth created by these institutions doesn’t reside with a few top-hat wearing, monocle-sporting fat cats – it’s in the pension plans and retirement accounts the majority of us are counting on to see our way through retirement. Look at
Bank of America's top shareholders and what you see are mutual funds and pension plan custodians, not hedge funds and wealthy plutocrats.
Similarly, look at a list of the largest investors in the country, and you see a similar run of custodians, headed by CalPERS, the California Public Employee Retirement System, with $180 billion in total investments, most of it in domestic equities.
Some managers and insiders at these institutions no doubt profited disproportionately from the paper gains they posted over the last eight years. But the collateral damage of letting those bastards twist in the wind is the financial future of teachers, firemen, nurses, and truck drivers around the country. This suggests to me, quite strongly, that remediation needs to be more targeted and focused than the nuclear-bomb approach of institutional failure.
There are certainly moral hazards associated with continued rescue of troubled institutions. The problem, as the UK Financial Services Authority learned when they initially signaled their intention to let Northern Rock go under as a proper consequence for their management failures, is that the consequences of bank failure extend far beyond the offending banks themselves. So that policy option seems to be off the table, and I hope this diary is of some help in explaining why, with the ultimate goal of fashioning an appropriate and realistic progressive response to the financial crisis.
Time permitting (and if there’s interest) I might address the nationalization issue next week – I think bonddad makes a lot of worthy points in his recommended diary, but the fact is that we are engaging in a de facto nationalization of many institutions, without the attendant oversight. I come down in the middle, in favor of a short-term, ICU-like approach to bank nationalization, with a clear plan for government exit in the medium-term once stability is restored. Full, open-ended nationalization is a remedy that far outstrips the underlying problem: with proper transparency and regulation in the financial markets, private-sector banks are in a much better position to balance the risks and rewards necessary to drive economic growth. What got us into this mess wasn’t that government didn’t have enough say in the day-to-day management of banks – it was that government didn’t compel banks to disclose the kind of information that would have led to much better management decisions and an avoidance of the credit bubble in the first place.
But that’s for another day....