Citigroup is in serious trouble. The storied institution with $2 trillion in assets has seen its shares collapse and its reputation is in tatters as it goes cap in hand to the U.S. government for a bailout. Indeed, a solution must be found as Citi is a monster of a bank, three times the size of Lehman Brothers, whose collapse caused untold damage two months ago. As I write this, Citigroup is meeting with U.S. Government officials to hammer out an agreement to set the firm on the right path. We can only hope these talks bear fruit.

However, the crisis at Citi highlights a number of other issues endemic to fractional reserve banking and panics that should have been addressed much earlier in this crisis. Yet again, a lack of foresight by authorities and a slowness to develop a comprehensive solution have led us again to a potentially cataclysmic loss of confidence in our banking system and much unnecessary heartache.

Fractional Reserve Banking

Let’s start all of this with a brief overview of why investor and depositor confidence is so critical in banking, more so than in any other industry. Wikipedia does a excellent job of summing up what Fractional reserve banking is.

Fractional-reserve banking is the banking practice in which banks are required by governments to keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) with the choice of lending out the remainder, while maintaining the simultaneous obligation to redeem all deposits immediately upon demand. This practice is universal in modern banking.

The crux here is that banks never have all of their deposits in reserve. Most of a bank’s deposits are lent out as credit. If every depositor came rushing back to any bank in most any country in order to demand access to their funds, the bank would quickly be declared insolvent. No bank can withstand a determined run on its deposits because they do not have ready access to the deposits. This dilemma is usually called “borrowing short and lending long” meaning that banks always suffer from an asymmetry between how quickly depositors can withdraw their funds and how quickly the banks can access the funds they have lent out. This is the Achilles heel of banking.

Insuring Confidence

What we have learnt over time is that the best way to avoid exposing our Achilles heel is to set up mechanisms to prevent a loss of confidence in specific institutions or the banking system more generally. These mechanisms include:

Minimum reserve ratios. All banking systems require that depositary institutions have a minimum amount of deposits on hand in order to meet depositor demand for cash. In fact, it is standard practice for these reserves to be held for safekeeping at the central bank and not at the bank itself in order to further safeguard the monies. Regulation. Banking systems have strict guidelines about lending practices. Violators will be stripped of their banking license and shut down to protect the integrity of the system. One common complaint of the recent mania is that laissez-faire orthodoxy seduced regulators into believing that the free market could discipline poor lending practices without strong regulatory oversight. Diverse funding sources. Banks often borrow money in the form of repurchase agreements, commercial paper and debentures which have longer maturities, meaning the bank does not have to repay the money lent “on demand.” Traditionally, banks were funded by demand deposits, which gave depositors the right to demand their funds in full at any time. However, as debt markets have become more liquid, a number of different funding sources have become available. Deposit guarantees. When bank runs wiped out the U.S. banking system in the 1930s, the U.S. Government decided to partially backstop banks by guaranteeing all individuals’ deposits up to a specified amount. Presently, that means that every individual theoretically has a $250,000 guarantee.

Panics and Bailouts

So, when panic strikes — as it always does eventually, the theory is that the aforementioned measures will calm otherwise jittery investors and depositors. And this has generally been true ever since deposit guarantees were established during the 1930s. A perfect example of this came in the 1980s. During that decade it became evident that Savings & Loans institutions were not being well regulated, had taken on too much risk, and did not have adequate returns to maintain solvency. The result: panic and bank runs. I remember the bank runs in Maryland, where I lived. In fact, Maryland is where the S&L crisis really began in 1985 because depositors started to panic that some S&Ls were privately insured. Depositors worried that this insurance was insufficient to cover their deposits, so they rushed to get their money out.

The funny thing about fractional reserve banking and runs is that once enough people start pulling their money out of a bank, everyone is incented to do so. Remember, only a fraction (10%) of deposits are actually on hand. If you think enough people are taking deposits out, you want to be one of the 10% that actually is able to access funds before insolvency comes.

In the case of the bank runs that started in Maryland and Ohio, the panic started to spread. As fear is the overriding emotion driving psychology during a panic, events become unpredictable and systemic risk becomes an ugly possibility. The authorities eventually had to step in and offer a comprehensive solution by bailing out the entire Savings and Loan system to the tune of hundreds of billions of dollars.

Our present crisis

Fast forward to the present day and one can easily find a number of prognosticators warning of systemic risk and the need for comprehensive solutions. Nouriel Roubini has been calling for action for a number of years. Dean Baker is another. In March, when Bear Stearns was bailed out, U.S. authorities had an opportunity to start a comprehensive plan. I pointed to the Nordic bailouts in the 1990s as a good blueprint for the U.S. and the U.K. in earlier posts as far back as June. Then, with the failure of IndyMac, the conservatorships of Fannie Mae and Freddie Mac and the collapse of Lehman Brothers, the U.S. authorities had yet more opportunities to recognize the seriousness of the crisis. Yet they dragged their feet and none has been offered.

The crux of the matter is that we are dealing with a panic and systemic risk. When Lehman Brothers failed, faith in the banking system in all western countries suffered devastating damage. In these circumstances, anything can happen. Authorities need to forestall worst case scenarios by acting sooner than later. Now, admittedly, much has been done to mitigate worst case scenarios, but most of it has been one-off ad-hoc solutions. My solution from a post in September went as follows:

An explicit government guarantee of deposits to end the worry about the solvency of the banking system. An independent agency to shut down, merge and liquidate insolvent banks. The independent RTC-like agency will make the determination for every single bank . The banks themselves will have zero say in the determination of the independent agency. The faster the liquidation process is complete, the sooner confidence will be restored. Separation of good assets from bad assets , not by buying them up at inflated prices, but by sticking bad assets into separate a separate “bad bank” entity at market prices. This will bolster banks’ counter-party confidence. Recapitalization of remaining solvent banks. This can happen through private monies. But, if necessary the government can get preferred shares or warrants or what have you. That way the solvent banks are re-capitalized and taxpayers get the upside. Increased regulation. Obviously this is what the public wants. Unless we can show how we are going to stop this from happening again, there will be little support. The new regulation may merely need to be explicit oversight of regulators by Congress as much of the problem is not the need for new regulation but enforcement of the regulations we already have. While we need this to get the bill supported, I am skeptical about the need for more regulation. Cap on pay. The independent agency will determine who needs additional capital and who doesn’t. Banks should be given a chance to raise capital in the private sector for a fixed number of days. Banks that need capital injections from the government will not have a say on pay caps as this will be mandated. Again, we have seen that people want this pay cap. Defense against politicization of the process. Having Hank Paulson or his successor controlling the crisis resolution process is setting the United States up for a politicization of the process. The regulator must be an independent body free of all political influence.

With the real economy now in free-fall, loss of confidence is back — and Citigroup is the most obvious loser. Citigroup is an enormous institution that is obviously too big to fail. Yet, here we are with Citi on the verge of collapse and one must wonder whether a more comprehensive approach might have prevented this outcome. Obviously Hank Paulson thought $25 billion was going to be enough to see Citi through.

What will it take for authorities to move to a more comprehensive bailout plan? Will the crisis at Citi be a watershed event for U.S. finance? I am still hopeful, but time is running out.

Source

Fractional-reserve banking – Wikipedia

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