Friday, September 23, 2011

Critical Facts About Banking

It's too bad there is so much uninformed thinking about the bank "bailouts."

The seeds of the 2008 crisis were much the same as the seeds for the bank failures in 1929 and the Great Depression which followed - the combination of commercial banking functions (credit services and payment systems) with investment banking (forming investment pools of capital.)

The banking system we established after the crash divided commercial banking from investment banking.

Commercial banks handled deposits, extensions of credit (lending) and especially our payment systems - originally check clearing, but also wire transfers and generally almost all payments in the stream of commerce. (No payment systems, no commerce. High risk payment systems, high costs for commerce.)

These three functions are so important to a smoothly running economy that we deemed the large commercial banks to be covered by an implicit "guarantee" of our central bank. the Fed" as the "lender of last resort. (That did not mean all banks would be automatically bailed out if they were failing - it did mean that the fed would support them in times of need.)

Payment systems are particularly vulnerable to cascading system failures - and without effective and safe payment systems, our economy as we know it could not survive.

Commercial banks were covered by a comprehensive set of regulations geared to assure the "safety and soundness" of the banks and the banking system.

Commercial banks were considered low risk, and thus low investment return.

Investment banks pooled the money of investors (excess capital) and disperse it as investment capital.

With investment banking, there is not the systemic risk that the payment systems have, and the money is money intentionally put at risk in investments.

The investment banking sector was high risk, high reward, with relatively few regulations beyond attempts to reduce business fraud.

For reasons not really germane here, commercial banks were, profits wise, sucking wind starting in the late 80s.

The "fix" was to allow commercial banks and investment banks to merge (through the 'repeal' of that separation in the Glass-Steagall Act) - bringing the high risk functions of the investment banks under the Fed's "lender of last resort" function so necessary for the payment systems and the universal need for credit.

And thus, we had the inevitable investment banking failures of 2008 and the inevitably critical need for the "bailouts" to rescue the credit and payment system functions.


  1. That's as clear an explanation as I've seen. Does Dodd-Frank reinstate the divide? I'm thinking it does not.

  2. My understanding of Dodd-Frank is that it doesn't come close to creating any sort of real separation or with dealing with the risks of our combined financial institutions.

    As initially drafted, it supposedly incorporated the "Volker rule" to split proprietary trading and hedge fund investments from banking. (Which hardly would have dealt with all the risks of today's banking.)

    My understanding is that even that limited Volker rule concept was watered down in the final bill, leaving too much risk in the 'entities' which also provide the essential services of providing credit and operating the payment systems.

    I believe one problem in analysis of these issues is the concept (red herring, in my view) of "too big to fail" as the relevant concern.

    I believe that the problem is that today's combined banks are engaged in both the high risk activities with the "extra" funds people and organizations have to invest [1] and the services essential to day to day commerce.

    I also discussed this last December, in the blog entry:

    = = = =
    [1] A good argument can be made that, today, the investment markets involve much more than discretionary excess funds available for capital investment; the the need for many collective activities such as pension funds for investment vehicles are a significant component of the pool of investment funds looking for sound investments. (Listen to, e.g.,

    As such, the next argument is that the risks that "Wall Street" is willing to undertake should be curtailed.

    OTOH, the losses to the American people through the pension fund losses didn't really arise from the investment bank's risk taking - they arose from the investment banks frauds and sale of the CDOs which had been improperly rated as of high credit worthiness.

    I don't recall the details, but the first round of derivative losses took place in the early to mid 80s.

    The banks had sold a lot of what some called "crap" to a lot of big investors, including pension funds.

    As I say, I don't recall the details and I wasn't directly involved, but I do recall conversations with my fellow bank attorneys who were directly involved with the 'crisis' in which they argued "the pension fund managers are supposed to be sophisticated investors, they shouldn't have relied on what our bankers told them."