Banking, the Federal Government and the Free Market

This week’s big market development was the announcement of proposed reforms for the flock of federal regulators that apparently “supervise” the banking system. You wouldn’t know there was much supervision going on based upon the events of the past year.

Predictably, we’re likely going to see the addition of another big bureaucracy in reaction to a crisis partially caused by a poorly structured banking system and toothless enforcement of existing regulations. The answer to the sloppiness of bureaucratic regulators is, apparently, another layer of bureaucratic regulators. Regulatory reform will not be effective if its architects incorrectly diagnose how the system blew up under the existing system of oversight.

The popular narrative is that that the financial crisis was a failure of the free market, but this narrative glosses over the fact that banking is far, far from a free market. Those who describe the banking business as a wild, woolly free market simply do not understand how banks operate — especially how, with government subsidies and backstops giving them the confidence to make insane loans, banks had grown large enough to blow up the entire global economy.

Last year was less of a failure of free markets than it was the failure of the “shadow” banking system built on a weak foundation: bankers’ lack of connection with the risks they underwrote, government guarantees and tax incentives for mortgages, and misapplication of statistics to exotic fixed income securities, to name just a few things. The shadow banking system could not have grown as large and dangerous as it did without banks’ subsidies from taxpayers and the Fed’s manipulation of the price of money. The Fed’s interest rate targeting creates illusions about default and liquidity risks and distorts the natural relationship between savings and capital investment.

The banking system shares much in common with the federal government, especially in their common isolation from the discipline of the free market; Free market discipline refers to the fact that if you make mistakes, your customers will let you know about it by leaving, and if you don’t reform and improve your product or service, you’re out of business. By promoting competition, free market discipline imposed on business has done more for “the little guy” than any government handout by spurring advances in productivity and living standards.

The banking system hasn’t been subject to free market discipline for decades, and it’s still not. Case in point: Bank bondholders and shareholders were bailed out — at taxpayer expense — from the consequences of their poor lending and investing decisions.

Unlike most businesses, banks don’t earn their profits by serving customers, but mostly by extracting huge economic rents from savers and borrowers. Otherwise, the financial system couldn’t have grown to be such a large percentage of GDP.

Banks are supposed to be intermediaries between savers and borrowers, allocating credit in a manner at prices (interest rates) in line with default risk. But they largely failed in this role. Most banks — especially the “too big to fail” banks — did a horrifically poor job of pricing credit risk at the peak of the credit bubble. Credit spreads were ultra low in early 2007, when it was one of the riskiest times in history to be making loans.

How did the banking system make such colossal errors in judgment about credit risk? I described a few critical weaknesses in the banking system in a September 2007 Whiskey & Gunpowder article (see link here). It wasn’t rocket science to figure out how interest rates were sending a distorted signal about credit risk; all you needed to do was follow the new credit back to its ultimate source and ask the right questions about the connections (or lack thereof) between saver and borrower. One would think thousands upon thousands of federal banking regulators — and those responsible for designing our financial regulations — would have the resources at their disposal to identify the structural weaknesses in our financial system.

Unfortunately, instead of providing a road map to designing a system that connects savers with borrowers in a more sane, responsible manner, it looks like the proposed banking reforms will give us more of the same. Such economic power concentrated in the hands of banks not subject to enough free market discipline is a problem, and the real economy will likely suffer from it.

Dan Amoss

June 23, 2009