A Financial System with Solid Foundations

The story of financial crises is one that’s as old as time. Bank runs have been occurring since the time of the renaissance, were a key factor in the great depression, and its variants have necessitated billions of dollars in bailouts in the past decade after the subprime crisis. Is this really inevitable? Is this really something that we simply need to accept and live with? I will be making the argument here that this is not the case.

Bank runs, and its derivative financial crises, all share one common root. A fundamental cause revealing the cracks in the system’s foundations. The dependency on public sentiment.

To put it simply, our banking system of present simply cannot function without people’s confidence. Even if the bank operations and balance sheet are perfectly sound, if enough people believe that they are in trouble and start withdrawing their money, these rumours and misguided fears will promptly turn into reality.

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To understand why this is true, consider what actually happens at a bank. Joe deposits $100 at his bank, in order to safeguard his money. The bank however, is not providing a simple service of safeguarding this money. It is also investing the money. The bank approves Mark for a mortgage, and lends him $80 to be repaid over the next 20 years. The bank now no longer has the full $100 that Joe deposits. It has only $20, and the other $80 is pawned away as a speculative long-term investment.

Now at this point, you may be wondering what would happen if Joe were to return the following week, and withdraw his $100. The bank no longer has it. It has only $20 of Joe’s money available. Thankfully, the bank is exceedingly clever, and has a solution for this. Joe is not the only depositor at the bank. So too are Alison, Adam and Amanda. So when Joe tries to withdraw his $100, the bank gives him back his original $20, together with $80 that actually belongs to Alison, Adam and Amanda. Over time, this $80 will be repaid by Mark through his mortgage payments, and Alison, Adam & Amanda will never even know the difference.

99% of the time, the system works exceedingly well. There are only 2 problems:

  1. What would the bank do if Mark defaults on his loan and does not pay back his $80?
  2. What would the bank do if Alison and Amanda also tried to withdraw their money the next day?

First, let’s consider case 1. The bank has 4 depositors, and using their pooled money, it had made a $80 loan to Mark. If Mark now defaults, the reasonable outcome should be for all 4 depositors to lose $20 each. However, that’s not how banks work. Losses are never accrued to the depositors, and banks simply return the entire balance to customers in a first-come-first-serve manner. The first 3 people to withdraw their money will get back their full $100, and the last person to do so will end up with only the $20 that’s remaining. Hence the term “bank run.” People are literally racing against each other to be the first few lucky ones, and not be the last one holding an empty bag.

Now let’s consider case 2. The bank has 4 depositors, with deposits totaling $400. Out of this $400, $250 has been loaned out as mortgages, and only $150 is sitting in the bank as cash. All the loans made are perfectly healthy, and the bank is receiving all payments as scheduled. Everything seems to be going fine.

However, a rumor starts that loans are being defaulted on. Most of the depositors know the rumor to be false, but Adam believes it and withdraws his entire $100. After all, he doesn’t want to be the one holding an empty bag if the rumor is true. Amanda knows that Adam withdrew his money, and that there is only only $50 remaining in the bank, so she rushes to the bank as well and withdraws the full $50. Alison and Joe, the only ones who were “responsible” and didn’t fall for false rumors, are now unable to withdraw anything from the bank because all the cash is completely gone. Despite their prudence, and also because of it, it will now be many years before they can ever recover their money.

These two cases perfectly illustrate why bank runs happen: During bad times, it devolves into a winner-takes-all and loser-gets-nothing situation, which leaves everyone scrambling to withdraw their money and not be one of the losers. And even during good times: uncertainty, fear, rumors and the mere threat of the above, can all send people similarly rushing to the bank, creating the very problem that was rumored to exist.

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For centuries, governments have tried to fix the problem by sweet talking people, whispering sweet nothings, and providing artificial government backed “guarantees” that promise more than they can ever deliver during a real panic. Consider for example, that the FDIC is responsible for insuring $9294 Billion worth of bank deposits, but it has only $25 Billion in its coffers to make good on this promise.

To put it generously, these “solutions” are mere hacks; temporary bandaids hiding the real problem. Any system of guaranteed fixed-deposits backed by speculative investments, is inherently an unstable one. It’s fundamentally predicated on the idea of “borrowing from Paul to pay Peter.” It may seem great during periods of calm. But during times of trouble, the bank’s guaranteed deposits simply do not line up with their assets, and no amount of sweet talking or confidence building can make up for this mismatch.

As an alternative, consider, how bond-funds work. These funds have been remarkably stable for decades. Despite lacking the type of guarantees provided by the FDIC, bond funds have never experienced any form of bank runs. The reason for this is simple: If some of the loans in their portfolio go bad, the loss is immediately borne out by everyone invested into the fund. It doesn’t matter how early or late you are in withdrawing, everyone loses the same relatively small amount. The fund’s liabilities to their investors, are always perfectly matched by their assets. This is what gives people the confidence to remain invested and stay with the fund, even while a select few panic and rush for the exits. Contrast this with banks, where the bank runs are in fact the rational response to times of panic.

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The problem with banks is that they promise more than they can deliver. They know it, the government knows it, and their customers certainly know it as well. But things don’t have to be this way. Let’s imagine an alternative banking system, that’s built on solid fundamentals and transparency.

If consumers want their money held for safekeeping in a risk-free, liquid manner, in checking accounts, it should be locked away in a metaphorical vault, and left to gather dust. It can still be accessible at any time using debit cards, checks, or bank withdrawals. But it should never be invested or loaned out to anyone. Your money should literally be sitting there, untouched by anyone else, waiting for you to withdraw it anytime you choose. In return, the same way you pay the postal service for delivering your mail, you should also be paying the bank some fees for storing and safeguarding your money.

If consumers instead want to loan their money out and earn interest in the process, through savings accounts, the money should be placed into equivalent bond funds, with the disclaimer that all profits and losses will be immediately and equally accrued to all fund-investors, on a daily basis. Customers wanting safe investments can choose funds that invest only in short-term government bonds, while more aggressive customers can choose funds that invest in long-term corporate bonds or mortgage loans. Each customer will be able to choose their desired fund, based on the amount of risk they want to take on, and the corresponding amount of interest they would like to earn.

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The above discussion has so far been concentrated on banks, but the same principle can be generalized to other financial systems as well. Any form of fixed guarantees, backed by speculative long-term investments, fundamentally leads to an unstable situation. As long as such systems exist, guarantees are bound to be broken, and panics are bound to occur.

The subprime crisis of 2008 has been an ominous precursor to bigger and more dangerous possibilities that await us. Whenever we’re dealing with unstable systems, it’s only a matter of time before a loose spark blows everything up. Let’s learn from 2008, and not repeat our mistakes all over again.

About OutlookZen

Ex-Journalist & Columnist. Loves exploring the world.
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3 Responses to A Financial System with Solid Foundations

  1. Rad says:

    What happened back in 1929? Can you also speak to the Asian Currency Crisis of 1998?

  2. Rad says:

    Another great post, btw.

  3. Pingback: Avoiding the next Financial Meltdown | Outlook Zen

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