Taleb: The essence of capitalism is encouraging failture

[moda0306]

The main problem with banking is fractional reserve banking.
Also known as "fraud" in any other industry.
If banks could only lend out deposits for the term of the deposit (or their own capital), and if the depositors couldn't withdraw their money before the end of the term, and the owners of the money (depositors or the bank itself) took the risk of lending, then banks wouldn't have to worry about runs.
That is the only safe model for banking.

I have two problems with this line of logic...

1) Everyone knows, or should know, what type of arrangement they're entering into.  In order for "fraud" to occur, I tend to think there has to be a victim.  We can choose to keep our balance in our checking accounts to a bare minimum to operate in a modern society and other than that completely withdraw from the fractional reserve system. 

2) I don't like the idea of the quantity, or lack thereof, of fiat (or gold) money in our hands limiting our productive potential.

[D1984]

That is the only safe model for banking.

Devil's advocate mode on/ If that is the case, how did we in the US have a banking system from the mid 1930s to roughly 1980 with comparatively few bank failures and almost none of the major financial crises/bubbles bursting like we see now every six to ten years...and this despite the fact that fractional reserve banking was quite legal then (albeit more regulated in many ways than it is today).

[MachineGhost]

Devil's advocate mode on/ If that is the case, how did we in the US have a banking system from the mid 1930s to roughly 1980 with comparatively few bank failures and almost none of the major financial crises/bubbles bursting like we see now every six to ten years...and this despite the fact that fractional reserve banking was quite legal then (albeit more regulated in many ways than it is today).

The problem isn't fractional reserve banking.  It's lack of limits on leverage.  The investment banks that collapsed were leveraged 40:1.... hardly all that different in concept from the LTCM failure in 1998.  The Fed itself has been leveraged around 55:1 since 2008, but since they don't mark to the market in a free market, does it even matter?

[Libertarian666]

That is the only safe model for banking.

Devil's advocate mode on/ If that is the case, how did we in the US have a banking system from the mid 1930s to roughly 1980 with comparatively few bank failures and almost none of the major financial crises/bubbles bursting like we see now every six to ten years...and this despite the fact that fractional reserve banking was quite legal then (albeit more regulated in many ways than it is today).

Just because something is risky doesn't mean that it will necessarily fail at any specific time. Fractional reserve banking is inherently vulnerable to bank runs and cannot be made otherwise; the timing of a failure is uncertain, as is everything in the future, but the risk is there.

On the other hand, 100% reserve banking is not vulnerable to bank runs, which was my point.

[stone]

A shock proof form of "banking" would be to say that all loans could only be funded by selling debt securities with the same time to maturity as the loan (eg 10year loan funded by 10year bond). Also all loans had to stay on the books of the loan company. The transaction system would be entirely separate and not entail making loans and simply be something like paypal.

Remember all of the debt in Germany was written down at the end of WWII. The slate was wiped clean. The banking system was rebooted. They then did very well from that starting point. We could have done that in 2008.

[AgAuMoney]

Devil's advocate mode on/ If that is the case, how did we in the US have a banking system from the mid 1930s to roughly 1980 with comparatively few bank failures and almost none of the major financial crises/bubbles bursting like we see now every six to ten years...and this despite the fact that fractional reserve banking was quite legal then (albeit more regulated in many ways than it is today).

Fractional reserve banking is stable until it isn't.  The system becomes less and less stable as reserves are reduced, and the motivation to reduce reserves is to increase profits.  The reserve requirements were significantly larger in the 1970's and earlier than they are now.  (Not sure when or how often they've been changed.)

[AgAuMoney]

Actually, what you described previously was a bond.  The term deposit makes it unable to have a bank-run by definition.  It doesn't make it any safer.

If instead, you had meant a 100% backed deposit with anytime withdraw (what most people think of as non fractional banking), then you only need to look as far as money market mutual funds as a working example of one in practice.  When certain ones were subject to breaking the buck, redemption rates rocketed.  That in all essence, was a bank run.

Matching deposit term to loan term makes it impossible to have a bank run, which by definition is safer.

Matching deposit term to loan term is a bond.  It could also be a CD or a savings account.  Most savings accounts TODAY have a several day and up to 30 day hold at the discretion of the bank.  CDs also, and they are usually at the longer end of that range.  Read the fine print.  How many times does that get pointed out and exercised by the bank?  Terms 7 days and longer could be matched to any kind of callable loan.  Non-callable loans need longer locked terms but perhaps could be worked with shorter mandatory holds and limits on withdrawal.  (e.g. you commit to 5 years, but can have 10% with 30 day notice)

As for "fully backed with anytime withdraw" it sounds like you are describing the correct implementation of a checking account. The only account today that allows anytime withdraw is a checking or more properly a transactional account and yes, that should be fully backed.

A money market fund is NOT an example implementation of such an account because 1) they are not fully backed (leverage), 2) they invest in non-liquid assets so are not term matched, and 3) are not bank accounts by definition.  I don't know if MMF's have withdrawal and/or transaction limits, but MMA's sure do.

The whole system is habitually skating on the edge and safety depends on mostly random chance where random is defined as sufficient majority of people and chance is defined by statistical models derived from historical data.  Currently we may actually be safer than pre-2008 since there are huge excess reserves in the system now (excess compared to ridiculously low requirements, not excess compared to amount on deposit especially amount on deposit compared to term).

[stone]

It seems to me that there are two completely separable functions. One is the payments system. That could potentially be a "full reserve system" just like paypal. The other is the lending system. Where we run into trouble is that we mix them up. We have a system where the payments system uses the debt from lending as the medium of exchange. That entails all of the hazards of maturity transformation and liquidity risks. It means that the payment system (a vital utility for the entire economy) is held hostage by the lending system. That creates a slippery slope towards bailing out an irresponsible lending system so as to keep the payment system intact.

If the payment system was just by something such as paypal and the lending system were separate; THEN it wouldn't matter if systemic credit defaults led to defaults on the bonds sold to fund loans. That would not impact on the vital role of the payment system. It would simply be irresponsible lenders getting what they had coming to them.

[Pointedstick]

Excellent point, stone. You're absolutely right.

[stone]

Slot line, isn't it much less expensive to store electronic ledger entries than to store gold? My guess is that it would be an extremely mundane utility. We would pay for it with a small monthly charge as we pay for water or internet or whatever. Now paypal is a fairly small market with little competition. If it were the entire payment system, economies of scale would drive the price right down.

I wonder whether another case of capitalism going off the rails due to protection from failure is the role of risk free assets in our whole economy. Treasuries and cash are assets that don't depend on the real economy doing well. Does that make us complacent about getting the economy back on track. They enable financial value to be transported through time irrespective of whether the economy goes down the toilet. Does that mean that we don't create a political rumpus to ensure that everyone (and every machine) is employed building the economy so that there is plenty go around. Instead we know that it is the people without the treasuries who will be left out if there is insufficient economic capacity built??? I had a go writing a blog entry about that: http://directeconomicdemocracy.wordpress.com/

[moda0306]

It seems to me that there are two completely separable functions. One is the payments system. That could potentially be a "full reserve system" just like paypal. The other is the lending system. Where we run into trouble is that we mix them up. We have a system where the payments system uses the debt from lending as the medium of exchange. That entails all of the hazards of maturity transformation and liquidity risks. It means that the payment system (a vital utility for the entire economy) is held hostage by the lending system. That creates a slippery slope towards bailing out an irresponsible lending system so as to keep the payment system intact.

If the payment system was just by something such as paypal and the lending system were separate; THEN it wouldn't matter if systemic credit defaults led to defaults on the bonds sold to fund loans. That would not impact on the vital role of the payment system. It would simply be irresponsible lenders getting what they had coming to them.

Excellent post.  Never really thought of it this way but amazingly simple and almost embarassing to not have organized my thoughts around it.

However, our country's base-money to credit-money ratio would have to do a huge shift for widespread defaults to do so little harm as you say. 

Further, I'd have a certain amount of nervousness about whether the businesses that make/underwrite loans were the same entities that owned the loans.  I think that piece is pretty huge.  You can't sell people's bad mortgages back to their very own 401(k) and not have moral hazards built into the system.

[Libertarian666]

Matching deposit term to loan term makes it impossible to have a bank run, which by definition is safer.

Matching deposit term to loan term is a bond.  It could also be a CD or a savings account.  Most savings accounts TODAY have a several day and up to 30 day hold at the discretion of the bank.  CDs also, and they are usually at the longer end of that range.  Read the fine print.  How many times does that get pointed out and exercised by the bank?  Terms 7 days and longer could be matched to any kind of callable loan.  Non-callable loans need longer locked terms but perhaps could be worked with shorter mandatory holds and limits on withdrawal.  (e.g. you commit to 5 years, but can have 10% with 30 day

You're right in that CDs and certain restricted savings accounts also fall into that term deposit group.  I chose bonds as an example because everyone is used to it having haircuts.  CDs/savings not so much so I didn't highlight them. 

From my point of view, when the loan goes bust your bond devalues hence it's no safer because there's no bank-run.  The trigger point is the same and the only difference is that you didn't have to leave the house for one of them.  The only valid argument for it being safer is if you're a slow runner - the loss is amortized across everyone regardless of running speed.

A money market fund is NOT an example implementation of such an account because 1) they are not fully backed (leverage), 2) they invest in non-liquid assets so are not term matched, and 3) are not bank accounts by definition.  I don't know if MMF's have withdrawal and/or transaction limits, but MMA's sure do.

1) not fully backed - legally, they may borrow up to 1/3rd of assets, but in practice they rely on little if any borrowing.  You're nitpicking.

2) illiquid assets - aside from a credit freeze that impacts everything, what is non-liquid about short term treasuries and commercial paper?  If anything, it's far more liquid than the long term investment loan banks normally make. 

2b) terms not matched - a corollary of withdraw anytime.  The comparatively low-risk nature of CPs and the overnight marked-to-market settlement of mutual funds give them an edge-up over any investment bank trying to do the same under onerous 100% backed rules.

3) not banks - the discussion centered around whether a fully-backed bank would prevent runs.  Since no such thing exists, the MMFs - which pretty closely meet all the criteria laid out - are the next best thing that show the limitations of such a scheme.  Please don't resort to tautology.

3b) withdraw limits - a MMF can freeze redemptions much like a bank undergoing liquidity issues can declare bankruptcy.  It's slightly different legally, but similar signal-response conditions.  It's also the one reason such a thing as a redemption run exists for MMFs.

The MMF redemptions came about because people were no longer confident in the remaining assets that the fund held and were scared to be the last ones locked-in.  That's not a fractional reserve thing.  That's a confidence thing.  And it applies just as well to any asset-backed liability.

I'd run on your bank regardless of whether it's fully backed or fractionally backed.

What you seem to be missing is that a "bank run" cannot cause failure of a 100% reserve bank that has matched terms for liabilities and assets. All that can happen is that they pay off the depositors under the terms of their agreements, and no one loses anything as a result of the "run".

Of course there is no such thing as a riskless investment, so if money is to be lent out, someone will take the risk of the loans not being repaid. However, there is no necessity for any loans to be made; the money deposited could be kept in a vault (much like Uncle Scrooge's vault), then paid out on demand. Obviously that will not provide a yield, but again there is no such thing as a riskless investment. If you want maximum safety, you don't get a yield, but instead pay for the service of holding your money.

By the way, if you look in HB's guide to Swiss banks, in it he mentions some banks that had over 100% liquidity; that is, they could pay off every depositor as they came in the door in a "run" without having any trouble doing so. So it is not only theoretically possible to have a bank like that; they used to exist within the last 35 years.

[MachineGhost]

If the payment system was just by something such as paypal and the lending system were separate; THEN it wouldn't matter if systemic credit defaults led to defaults on the bonds sold to fund loans. That would not impact on the vital role of the payment system. It would simply be irresponsible lenders getting what they had coming to them.

Bitcoins me for !!!

[stone]

moda

our country's base-money to credit-money ratio would have to do a huge shift

I was thinking that thanks to QE we already have mountains of base money. If new regulations meant that all lenders had to match the maturity profile of their liabilities to that of the loans on their books, then banks would start issuing lots of 10 year bonds and CDs and such like. The current pool of bank deposits would get converted into such longer term debt; so not so much immediate maturity money would be in existence. People would then move just what they needed into the payment system institutions just as we now do with Paypal accounts. My guess is that the current stock of bank reserves is ample to cover that.

[moda0306]

stone,

I guess I haven't done a full-blown analysis, but people currently expect their deposits to be liquid, not turned into 10 year bonds.  To match up our deposits to terms on the loans overnight would piss a lot of people off.  That's why I think we'd need some more base money to enter the system or something.

[stone]

stone,
I guess I haven't done a full-blown analysis, but people currently expect their deposits to be liquid, not turned into 10 year bonds.  To match up our deposits to terms on the loans overnight would piss a lot of people off.  That's why I think we'd need some more base money to enter the system or something.

Sorry I was unclear. I meant the bank would sell bonds. People who so chose could buy them. They would need to be enticed by the interest rate offered. In that way the banks would entice people to voluntarily convert their bank deposits into longer term bonds.

Banks already do a lot of such asset and liability management to keep the maturity mismatch under control.

[stone]

I guess many people could keep savings in the form of an ETF of bank bonds or some such set up. So if you wanted to buy a car, lets say, you would sell some of your holding of the "total bank bond index ETF" and use that via your paypal account to buy the car.

Banks would in fact not be banks as we know them. To make loans you don't need a banking license. AFAIK you only need a banking license if you do the whole maturity transformation right down to demand deposit ie zero duration. I guess the lenders would be the most conservative style of savings and loans companies. So the ETF of the bonds of such institutions would not be a wild ride like a current bank bond ETF is.

[moda0306]

stone,

Makes sense... my only problem is that most people don't have money in the bank that they would consider investing long-term.  I guess I could be enticed to investing some of my cash, but in the end, I keep my money in checking and savings because I need that liquidity. I accept a lower rate of return in exchange for liquidity. The shift would completely change the equilibrium between liquidity and debt in this country so I'm just really careful in thinking through how this would actually work... though it'll never happen so why try .

Now of course, one could always "sell back" a loan to the bank @ FMV, or transfer it, so maybe I'm thinking too inside the box.

Good to see you commenting again.  Let's just try to stay away from asset tax and citizens dividend debates for a while .

[stone]

moda, I think an ETF of bank loans would be a liquid saving vehicle. The price might have a little volatility but as I said it might be much less than might be imagined.

Too late about asset tax and citizens dividend   http://gyroscopicinvesting.com/forum/ht ... ic.php?t=5

I actually think a robot future potentially solves one of the biggest "issues". When lots of brute labour was needed, any industrialist needed to have a potential workforce who were desperate to work for him. When America was being colonized every new comer wanted a farm of their own rather than working as an employee and so there was a labour shortage. First indentured labour was used to provide staff then that morphed into bringing slaves from Africa. It used to be necessary to have a downtrodden class of people.
In the robot future we would just need people who knew what to set the robots doing (eg set the robots inventing better robots with certain characteristics). Potentially everyone could be in the owning class. Obviously that would require the wisdom (as I see it) to recognize the need for a certain level of wealth equality.

As Jeremy Grantham put it:
“the final position is that automation, and thereby capital, produces everything while all of
the mere mortals sit on the beach. And starve? The worthless unemployed who are
obviously not carrying their weight? Ah, there’s the rub! Up the beach, in a protected,
cordoned-off section is the capital owners’ club. There, a handful of equally
“unemployed”?owners sit, enjoying tea and the ocean.”?

All we need to do is to move everyone into the "capital owners' club" with (you guessed it) an asset tax and citizens' dividend  .

and if you want any more I've started a web site just for that  http://directeconomicdemocracy.wordpress.com/

[stone]

The PayPal expenses breakdown shows that even in electronic transactions, the cost is still there in terms of managing security, reconciling things like chargebacks, collecting on fraudulent activities, etc.  I'd say most of this is because they don't hold the money in physical form but rely on ledger accounting.  People expect it to be recoverable unlike real cash transactions.
You'd have to throw a lot of the baby out with the bath water like what bitcoin does in order to actually be cheap.  And PayPal isn't cheap.  The recipient pays on behalf of both parties.  A percentage that's actually higher than gold storage

Wouldn't there be a lot of scope for economies of scale?

I guess we do now pay indirectly for all of the admin costs of banks running the payment system. It would just be more upfront.

[MachineGhost]

If we're willing to put up with bandits on the highway again, then we can drop 'em.

That didn't work out so well for e-gold...

[AgAuMoney]

PayPal without the bill me later mess   their risk section in the annual report scares me.

No doubt.

It's a nice idea stone.  It's too bad everyone keeps crossing that line.  A fully detached payment system would also have the problem of money storage, necessitating storage fees and other fine details.  Don't we have this problem with gold funds?

Yes, but again it comes down to legal requirements or contractual agreements, violation of which can be penalized, vs. the present model of how far can you go, maybe just a little bit more, more, more, ...  WHOOPS!

I think a legal separation requiring 100% reserves for checking accounts and more strict (or at least more notice paid to) transaction limits on savings accounts could work.

Yes, it would likely mean a checking account would incur costs.  But I'd rather them be up front about the cost to provide that account than to hide the cost behind a veil of risk that few if any understand.

Further, I expect that the cost could easily be paid by locking up a certain amount of capital in either a savings account or CD where it couldn't quickly be withdrawn (or the cost for the checking account would have to be prepaid for the next month or two or three before the withdrawal could be taken).

For example, one of my current checking accounts has a requirement that it must have a $1500 minimum balance, or else every month at least one bill pay along with one or two deposits totaling at least $1000 (more deposits are OK as long as at least $1000 can be found in one or two of them), or else they charge me a fairly stiff monthly fee.

It happens to be the account I have tied to paypal so I don't want to keep much money there, and it is tied to a few other services with rare transactions so I do not want to give up the account, nor do I want to pay a monthly fee.  So I run my mortgage payment thru it every month.  Money in, a day or two later money out.  If they told me the only choice was the minimum balance, I'd ask about pooling separate accounts and keep the balance in the other account, most banks allow that kind of thing.  If they required the monthly fee or too big an increase in the minimal balance I'd be willing to go thru the pain of closing that account if better terms were still to be found elsewhere.  (I really liked the prior owner of this bank.   And the credit card with the $30,000 limit that these guys cut down to $500.  Seriously???)

[AgAuMoney]

And PayPal isn't cheap.  The recipient pays on behalf of both parties.  A percentage that's actually higher than gold storage

Yeah, turns out that running a transaction system costs more than tending stuff that just sits there.  And then there is the whole fraud prevention and recovery business, and KYC/AML compliance, and ...

Bitcoin is now where paypal was about 15 years ago.  People thinking of starting a financial service business with no prior experience really have no idea...