Most of you are familiar with the usual plot of most zombie movies. Everything is fine until one day when space dust, a new virus, or occult practices start causing the dead to re-animate and spur within them an insatiable lust for human blood. The principals in the movies take some time in figuring out how to fight back, usually spending a lot of the time running from zombies coming from every direction. But then, at some point, someone realizes that the only way to stop the zombies is to shoot, puncture, explode their heads (and sometimes hearts in some movies).
The way you kill a zombie is to shoot it in the head.
Today, our banking system, is a zombie. Instead of hungering for human flesh directly, it hungers for our cash. But where is the head on this zombie located, where can we focus our actions to actually kill these zombies, rather than running from them with no hope of relief?
The answer lies with the concept of 'hot money.'
'Hot money' in the banking industry is officially known as brokered deposits. Say a community bank, with a long history of responsible lending in your town, decides that it wants to grow and be as profitable as the megabank down the street. The only way a bank can grow is by attracting more depositors. New toasters can only go so far in attracting new depositors in today's marketplace, but small banks have other alternatives.
Small banks can turn to the brokered deposits industry. A company like Merrill Lynch has large amounts of cash that have been invested by individuals and organizations into safe investments like certificates of deposit and money market funds. These investments are considered some of the safest and most secure out there. But Merrill Lynch isn't doesn't like the idea of having its equities investments (stocks, etc.) being used to cover the interest they guarantee with their cash investment opportunities, so they have created the brokered deposits market.
Merrill Lynch can offer to set up FDIC-insured deposits in that small community bank if the bank will offer them a preferential interest rate (a rate higher than a member of the community will get and that other small banks are offering). This gives the small bank the capital it needs to grow. The bank then can make more loans. But for the small bank to make money, it needs to make riskier loans, so that it can have a large enough spread on interest to make serious profits. So these small banks start shoveling money out the door to whoever has a good idea -- developers with new sprawl divisions or strip malls, sub-prime loans to those individual depositors, and other complicated financial lending instruments.
But what happens then? Well some small banks in this past decade have grown significantly due to hot money, but many of them are starting to pay the piper, because money of the loans they have made are going bust. Almost all the banks shut down by the FDIC this year are due to 'hot money' issues. And the brokered depositors are treated like any other depositor.
Though few people have heard of it, hot money — or brokered deposits, as it is also known in the industry — is one of the primary factors in the accelerating wave of failures among small and regional banks nationwide. The estimated cost to the Federal Deposit Insurance Corporation over the last 18 months is $7.7 billion, and growing.
'Hot money' is called hot because the brokered deposits can leave the bank they're parked anytime better rates come calling. So if a banks deposits are made up of a significant percentage of brokered deposits, the culture and the operating principles of the bank change accordingly. Short-term profits over long term sustainability, the very ideas that many of us associate with community banks. Very zombie-like.
And when a bank is failing, the brokered depositors are going to know and have the added leverage of being able to move their money out (possibly precipitating a failure) as well as FDIC insurance.
I suggest that people read the NY Times article linked above. It gives a good overview of how 'hot money' is the zombie ju-ju of this economy. This has been an issue since Penn Square bank in Oklahoma City collapsed in 1982 setting off the S&L crisis. For a larger context, people need to realize that the money-market is much larger than the equities market on Wall Street. And every time there has been an attempt at nominal regulation it has been beaten back by the small and large banks lobbying efforts. And this is now a global market. Small banks are competing against banks in Europe and the global South for these dollars, though that is somewhat mitigated by capital controls in various countries, especially SE Asia after going through similar problems.
Common money market instruments
* Bankers' acceptance - A draft issued by a bank that will be accepted for payment, effectively the same as a cashier's check.
* Certificate of deposit - A time deposit at a bank with a specific maturity date; large-denomination certificates of deposits can be sold before maturity.
* Repurchase agreements - Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.
* Commercial paper - Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value.
* Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located outside the United States.
* Federal Agency Short-Term Securities - (in the U.S.). Short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.
* Federal funds - (in the U.S.). Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.
* Municipal notes - (in the U.S.). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues.
* Treasury bills - Short-term debt obligations of a national government that are issued to mature in three to twelve months. For the U.S., see Treasury bills.
* Money funds - Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors.
* Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future.
The money market is where most of the actual investing goes on. And it is interesting, knowing how a lot of these shaky loans were then sold to other companies, that in turn created MBS (mortgage backed securities) or ABS (asset backed securities) which fed the development of CDOs which were then sold back to many of the players in money-markets, like municipalities, small banks, pension funds, etc. All the while, the large investment houses on Wall Street were sucking up cash at every point.
Investment houses don't like cash sitting because that is a money losing proposition in a low-inflationary environment. They like to move that cash and multiply it all along its trajectory. And like all things, this is good in moderation. But we have had a system where banks can get unlimited amounts of this 'hot money' which leads to immoderate growth in their respective local economies and now we are all paying the price.
Any serious financial regulation is going to have to address this issue.
Late last year, the F.D.I.C. proposed a new rule. Banks that rely too heavily on brokered deposits to accelerate their growth will have to pay a higher insurance premium to help cover losses if they fail. The proposed limit was 10 percent brokered deposits and a growth rate of 20 percent over four years.
Just as it did in the early 1980s, industry opposition emerged almost overnight. ....
The banks won important concessions. The regulator relaxed the part of the rule that required higher premiums if banks grew too fast with brokered deposits, allowing a growth rate of up to 40 percent over four years. And it left open a loophole that lets banks — even those considered unsound — turn to a "listing service," a source of hot money by another name. Instead of paying a broker, banks pay to subscribe to an electronic bulletin board of credit unions with money to park.
But this will be an epic battle because many of these banks believe it is their right to zombify at their convenience. The attitude of Wall St., that we are smarter than you, that we know better than you, is an attitude that infects Main St. as well. Local bankers have an outsize influence on local politics in many parts of the country. The change we seek is going to have to come from the local level. And beyond this, the US government is beholden to these interests even moreso than they are beholden to China's interests, as the largest group of investors in Treasuries are US nationals (a group that includes community banks).
What I hope people realize is that this one activity of brokered deposits works against many of our progressive ideas about transforming this country. 'Hot money' incentivizes many of the bad practices municipalities engage regarding city growth and development. As long as there is unlimited cash available for the banks that want it, there are going to be incentives to move that capital into unsustainable projects that do not add to the productive capacity of this country. It is ultimately about valuing the short-term bursts of growth over the long-term stability of our economies, locally and regionally. And I realize that this is one part of the problem, but it is a serious structural flaw in capital-allocation, a flaw that has had serious consequences around the country. So I hope I educate a few of you about this issue, as well as, being educated in the comments. I'm sure there is an expert or two out there who will comment on the validity of some of these assertions.
As far as I can tell, a reasonable regulation would be to limit brokered deposits to some percentage of total or actual deposits in the bank, and/or tying the FDIC insurance premium to the various percentages of brokered deposits and forcing investment houses like Merrill Lynch to pay a transaction premium for moving deposits around, as well as having a non-loophole definition of what qualifies as a brokered deposit. All of these actions would cool the 'hot money' market without killing it, as well as insuring the FDIC has the resources to unwind banks once we return to a more normal system of growth/recession centered on the dynamics of the business cycle, which this recession is currently not, in my lay opinion.