Money Sage (archive)

A simple question deserves a simple answer. We will pose our simple question, without any hope whatsoever that we will receive any answer, simple or otherwise.

Our simple question is this: What are BANKS doing gambling with tens or hundreds of billions of their capital in the futures and derivatives markets?

Let us begin at the beginning. You deposit money into your bank account. You have worked hard this week, avoided spending your entire paycheck, and are rightly proud that your care and prudence have enabled you to put a bit away for the proverbial -- but all too inevitable -- rainy day. Or, you have deposited your social security check, your pension check, your dividend check, your rental income payment, or whatever.

Your requirements of your bank are simple and reasonable. All you ask is that the bank provide the promised interest on your deposit and that it be able to return your deposit should you need, or desire, use of the money. Now, you are not a totally unsophisticated individual. You realize that the bank cannot pay you interest on your deposit unless it is able to earn some money on said deposit. These earnings must be sufficient to pay the interest on your deposit, cover the bank's cost of doing business, and produce a decent return for the bank's owners (i.e., shareholders). After all, you understand that there is a lot of competition for capital, which can be employed to finance just about any kind of business enterprise. If banks do not earn enough money to pay shareholders a nice dividend, no one will buy bank stock, no one will supply capital to enable your bank to roll over its debts when they come due, or to pay the obligated cash to depositors in case a fair number of them demand return of their deposits at roughly the same time.

You, the depositor, are not an idiot. You understand these elementary truths.

You also understand that in order to meet the obligations necessary to begin a banking business, and to sustain same, the bank must TAKE RISK. The question is: how much risk?
Since there is so much at stake for the generality of depositors, as well as for the overall financial system and the economy, you expect the bank to BE PRUDENT in its risk-taking. Clearly, in an age of instant communication and the ubiquity of the internet, and the consequent downward pressure on price (which, in the case of banks, equates to downward pressure on profit margins as a result of upward pressure on the rate of interest they must offer depositors, since prospective depositors can instantly, via the internet, access the identity of competing banks which pay a higher rate of INTEREST), banks need to find ways to earn a HIGHER RETURN than in the good old days, when lack of information induced depositors to hand over their money for very low rates of interest. During the good old days, the bank was able to produce healthy profits in consequence of the scarcity of information, and access to same, by the generality of depositors. This meant that, objectively speaking, banks DID NOT HAVE TO TAKE TOO MUCH RISK with depositor money in order to maintain a functioning, profitable enterprise.

Of course, this did not necessarily mean that banks did NOT TAKE too much risk, and did not suffer serious negative consequences when things turned sour. All it meant was that they DID NOT HAVE TO TAKE SO MUCH RISK. Human greed, hubris, and the tendency to herd behavior in speculation led many a bank astray, and many a group of depositors to consequent disaster. HOWEVER, WE MUST ACKNOWLEDGE that the "online revolution" and the instanteousness of access to information has, OBJECTIVELY SPEAKING, FORCED BANKS TO TAKE ON MORE RISK.

Simple bank-bashing will not do; in truth, it is not really appropriate. It would be UNREASONABLE, we think, to expect or require banks to police themselves. It is simply asking too much in a hyper-competitive and very difficult environment in which banks are constrained to operate in contemporary times.

However, bank risk-taking MUST BE LIMITED. IT MUST BE REGULATED. That is why we have REGULATORS. It is up to the regulatory authorities -- most importantly, the Federal Reserve -- to DO THEIR JOB -- TO REGULATE. Abdication of this responsibility a la Greenspan/Ayn Rand must inevitably produce a catastrophe. Such as we now see unfolding before our very eyes.

We cannot tell the regulatory authorities where to draw the line. All we can say is that it is clear beyond the shadow of a doubt that they HAVE NOT DRAWN THE LINE TO AN EVEN REMOTELY APPROPRIATE DEGREE. Yes, rogue traders and the failure of a bank's internal risk controls can aggravate a dangerous situation. This is like a paper cut aggravating the blood loss deriving from an aortal hemohhrage. The GREAT BULK OF THE FAILURE IS THE REGULATORS'. Yes, it is a tough job -- but that is what they are being paid for. We all pay for their absenteeism. A real maestro does not leave the podium in the middle of conducting a symphony so that he can enjoy an elaborate meal at a restaurant.