Friday, February 13, 2009

What is a Bank?

I'm trying to get at what people are talking about when they keep talking about the banking system.  Back in the day, it was pretty easy to figure it out.  Banks had buildings with tellers and FDIC insurance.  Brokers didn't.  No one had ever heard of an investment bank.

It goes back to the 30's.  The Glass-Steagall Act.
Mr. Glass: Here [section 21] we prohibit the large private banks whose chief business is investment business, from receiving deposits. We separate them from the deposit banking business.
Mr. Robinson of Arkansas: That means if they wish to receive deposits they must have separate institutions for that purpose?
Mr. Glass: Yes.
Basically that means that if you take insured deposits, you have to get out of the direct investment business.  That was then and this is now.  Glass-Steagall had a number of restrictive reforms that were inefficient.  It also created a safe, regulated sandbox for the average citizens and a less regulated one for those that wanted something different.  It was chipped at for years, and is now mostly gone.

Right now, the FDIC insured institutions have about $13 trillion in assets and $7 trillion in loans.  The past 5 decades have been primarily a process where more and more transactions took place outside of regular banks.  Money Market Funds were started in the early 70's and bought high grade commercial paper.  This used to be a staple of banks.  Just an example, but the regular banks tended to get "disintermediated."

You had money center banks that were somewhere between investment banks and vanilla banks.  Then you had your pure investment banks, your brokerages, and the like.  

Regular banks can go bust -- witness the S&L crisis.  However, it is a pretty simple business.  You "make assets" like loans of various types and fund them with a layer of capital and deposits.  Normal people can do this without computers.  The did for decades.

Everyone knows that you don't let your vanilla banks get to fancy, and that they need to have an organized process if they fail.  Basically, the FDIC comes in, declares it insolvent, turns the deposits (liabilities) and an equivalent amount of cash to another bank, and the depositors are up and running the next day.  The FDIC then has the residue, which consist of loans of various quality levels and the collateral that is rounded up from the busted loans.  

Then you have your capital markets operations.  This stuff is done by investment banks, brokers, etc.  Normal people can't understand it.  They didn't understand it.  It used to be hived off.

However, this is the area that is both failing and difficult.  It is also an area that got crammed back into the regulated banking system and supported with taxpayer funds.  Why?

Basically because if you tell the public, it's the banking system, they know it is important and can't fail.  If you tell them it is brokers and derivative salesmen, they are likely to say no.  So, if you want to bail out the capital markets people, regardless of where they are nominally hiding, you have to call them bankers.

Therefore, JPM acquired a huge deposit base, then scarfed up Bear Sterns, then grabbed another huge deposit base via WaMu.  City has always been a mess in one way or another, and managed to have a decent sized deposit base, although as a "money center bank" it has been been too big to fail and bailed out once already.  But in spite of its deposit base, it never was a regular bank.  Then you had Merrill Lynch absorbed by Bank of America.  Goldman and Morgan Stanley became regulated banks to grab some TARP funds.  

All of a sudden, Wall Street is pretending to be regular banks in order to tap into the bailout funds.

I don't really know if Wall Street is essential to the financial system, but, unfortunately there is a decent argument.  So much credit has bypassed normal banks via securitization that you can't say they aren't important.  However, it is a stretch to call them Banks, except to confuse the public.  

People are going nuts about nationalizing the banks.  Anything that was similar to the traditional bank has already been worked over, and the worst are history.  Indymac - gone.  WaMu - gone.  Wachovia -- gone.  National City - gone.  Not nationalized, but the stockholders were pretty much wiped out, the assets written way the hell down, and moved to someone that appeared stronger.

This is maybe 15% to 20% of the deposit base of regulated banks.  So what is it that needs to be nationalized?  It is Wall Street pretending to be regular banks.  However, they have tended to get so tangled with regular banks that it is hard to sort things out.

Unmerge BAC and MER.  Let Goldman and MS keep their TARP loans for another year or two and then pay them back.

The vanilla banking functions can continue without too much disruption.  The community and commercial banking functions can be cleaned up easily enough.  

The Capital Markets stuff is the real mess, and I have no idea how to really deal with them.  However, I would assume that the worst abuses were in the past and there is never going to be anything resembling justice.  Once you forget about that, it is just a pragmatic calculation of whether it is cheaper to bail them out or unwind them as quickly and orderly as possible.    


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