What's Wrong With The U.S. Banking System?

What's Wrong With The U.S. Banking System?

What's Wrong With The U.S. Banking System?

Every time there is a banking crisis, many people scratch their heads, wondering how this could happen. 

Surely it must be greed, bad risk management or lack of regulation. More intervention should solve it. However, all those excuses miss the most critical point: The U.S. banking system was destroyed by design, and the big banks played along with it.

The fractional reserve system has always been a problem. Very few people understand how quickly the capital of a bank can dissolve. The entire balance sheet of a bank is a deck of cards and the smallest decline in the profitable asset base -loans- or the volatile liabilities -deposits- would make the entire building collapse because the problem has always been to take additional long-term risk using short-term liquid liabilities -deposits-.

The mismatch between assets and liabilities makes the entire balance sheet collapse and there is never enough capital and reserves to cover the losses. However, decades of prudent banking and increasingly sophisticated risk management tools helped reduce the risk of a bank failure. It was never going to be perfect, but it worked for the most part.

The real problem started when the “monetary innovators” decided to invent the wheel and ignore what money and risk are. This time was going to be different.

And easy money destroyed the banking system step by step.

Phase one: Make the lowest risk asset, sovereign bonds, artificially expensive through quantitative easing (QE) bond purchases. This, in turn, would make governments recklessly increase deficits and forget about solvency or risk because the yield of their bonds would remain depressed through money printing. “Creating reserves” as the idiotic MMT calls it. Say goodbye to the profitable side of the bank’s asset base. Banks would take increasingly higher risk for lower yields in their investments and liquidity-enhancing portfolios.

Making the lowest-risk asset expensive and unprofitable by depressing the yield artificially also makes all other quoted and unquoted financial assets more expensive, incentivising bubbles that inflate with QE and, when they burst, evaporate the market value of the assets of a bank.

Phase two: Introduce negative real or nominal rates. Interest rates are the price of risk. Manipulate interest rates, and you incentivise extraordinary risk-taking even if the bank does not intend to. Negative rates are the destruction of money and the clearest way to make the balance sheet of a bank even more fragile: The loans side of the asset base make no real return, the leverage on those loans needs to rise, banks take more risk than expected for lower return with each lending operation, and the investment side is full of increasingly overvalued assets that rise with quantitative easing despite weak economic conditions but burst at the same time.  

Phase three: Bail out the big banks, let the small collapse. The latest perverse incentive is to make whole the depositors of large banks through a special assessment in the FDIC (Federal Deposit Insurance Corporation), which creates an incentive for large depositors to take their money away from regional and small banks and place it at “too big to fail” banks. However, the “too big to fail” banks are also the ones that accumulate more risk in large zombie firms and big derivatives positions taken to try to squeeze some margin and returns out of financial repression.

This is how banks are destroyed by easy money. No amount of regulation can avoid these collapses because regulation is the problem.

No amount of regulation can prevent a financial crisis when it is the regulator who incentivises accumulation of risk, deems sovereign bonds as “no risk assets” and the supervisor prints trillions of dollars disguising risk with negative rates.

Bad risk management? Maybe. However, do we think that the risk managers at the failed banks were stupid and did not understand the risk of asset and liability mismatch? Banks only accumulate risk in the assets they see and are told have no risk. The Federal reserve purchases trillions of sovereign bonds and mortgage-backed securities? Why would anyone think those are high-risk assets? Real estate is the safest activity to lend because the last thing that families stop paying is the mortgage. Why believe it is a high-risk asset?

However, it is much worse. A decline in value of bonds, mortgages or investments should not bring the collapse of a bank and a contagion risk. What makes it so fragile? The fact that banks need to leverage those positions multiple times to get a return that, even after increasing debt, is still below cost of capital. And why is the return on assets and equity so poor in banks? Years of repression of interest rates and inflation of sovereign bonds.

The reader may say that easy money has helped the economy recover from a severe crisis created by excessive risk-taking, yet it seems that no one remembers that the real estate and tech bubbles of the past were fueled by cheap money incentives created by the regulation and the central bank.

If rates floated freely, the interest rate on riskier activities would rise faster and prevent accumulation of risk. Furthermore, if central banks did not perpetuate the disguise of risk through purchases of sovereign bonds at any price, the lowest-risk asset would not create a domino effect of valuation and price increases nor the subsequent collapse.

When central banks decided to solve a crisis created by a bubble by inflating other bubbles even faster, they built the foundation of the next crisis.

A bank collapse is not the cause of a financial crisis. Banks are not the cause; they are the symptom. The assets and liabilities of a bank are the clearest evidence of the broad problems in the economy, elevated valuations beyond fundamentals and riskier loans than solvency dictates.

A bank collapse does not create contagion risk. The risk is already there. The bank that collapses, usually a weak link in a long chain, is only the warning sign of something that is widespread and happening elsewhere.

Banks are not the cause of a crisis. They are the symptoms of the accumulation of excessive risk throughout the economy, a risk that would not have been built in such a widespread way if the price and quantity of money were not constantly manipulated to disguise it.

This crisis will also be solved by incentivising more risk.

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Daniel Lacalle

Global Economy Expert

Daniel Lacalle is one the most influential economists in the world. He is Chief Economist at Tressis SV, Fund Manager at Adriza International Opportunities, Member of the advisory board of the Rafael del Pino foundation, Commissioner of the Community of Madrid in London, President of Instituto Mises Hispano and Professor at IE Business School, London School of Economics, IEB and UNED. Mr. Lacalle has presented and given keynote speeches at the most prestigious forums globally including the Federal Reserve in Houston, the Heritage Foundation in Washington, London School of EconomicsFunds Society Forum in Miami, World Economic ForumForecast Summit in Peru, Mining Show in Dubai, Our Crowd in Jerusalem, Nordea Investor Summit in Oslo, and many others. Mr Lacalle has more than 24 years of experience in the energy and finance sectors, including experience in North Africa, Latin America and the Middle East. He is currently a fund manager overseeing equities, bonds and commodities. He was voted Top 3 Generalist and Number 1 Pan-European Buyside Individual in Oil & Gas in Thomson Reuters’ Extel Survey in 2011, the leading survey among companies and financial institutions. He is also author of the best-selling books: “Life In The Financial Markets” (Wiley, 2014), translated to Portuguese and Spanish ; The Energy World Is Flat” (Wiley, 2014, with Diego Parrilla), translated to Portuguese and Chinese ; “Escape from the Central Bank Trap” (2017, BEP), translated to Spanish. Mr Lacalle also contributes at CNBCWorld Economic ForumEpoch TimesMises InstituteHedgeyeZero HedgeFocus Economics, Seeking Alpha, El EspañolThe Commentator, and The Wall Street Journal. He holds a PhD in Economics, CIIA financial analyst title, with a post graduate degree in IESE and a master’s degree in economic investigation (UCV).

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