Deposit Insurance, Fannie Mae. Freddie Mac, Fat Tails, FDIC, Fractional Reserves, Frank Hollenbeck, GSEs, Guatam Mukunda, Gvernment Sponsored Enterprises, Irving Fisher, It's a Wonderful Life, John Cochrane, Laurence Kotlikoff, Milton Friedman, Nassim Taleb, Ralph Musgrave, rent seeking, Skin in the Game, Too big to fail
Risk taking is important to the economic success of a nation. Creative energy demands it, and it is critical to achieving economic growth and wealth creation. But it’s obviously possible to take too much risk or risks that are ill-considered, and that is all the more likely when risk-takers are absolved of the consequences of their actions. That is, healthy risk-taking and responsibility are inextricably linked. One can’t truly be said to take a risk if the cost of failure is borne by another party. It’s easy to understand why risk-taking becomes excessive or misdirected when that is the case.
There are various ways in which a party can parlay risky undertakings into easy gains by shifting the risks to others. For example, any piece of merchandise comes with the risk that it will not perform as advertised. Some traders might be tempted to sell unreliable merchandise and shift risk to the buyer without recourse. This is an area in which we must rely on a bulwark of private governance: caveat emptor. On the other hand, government tends to subsidize risk-taking in various ways: limited liability under the corporate form of business organization, bank deposit insurance, bankruptcy laws, the implicit government guarantee on mortgage assets, and the “too-big-to-fail” mentality of government bailouts.
Whose Skin In the Game?
These are examples of what Nassim Taleb bemoans as the failure to have “skin in the game”. The quoted expression happens to be the title of his new book. I have both praised and castigated Taleb’s work in the past. He made an interesting contribution about the nature and risk of extreme events in his book “Black Swan”, such as his application of so-called “fat tails” in probability distributions, though some have claimed the ideas were anything but original. I was highly critical of Taleb’s alarmist hyperbole on the effects of GMOs. In the present case, however, he considers “the asymmetry of risk bearing” to be a major social problem, and I’m generally in agreement with the point. The most interesting part of the brief discussion at the link is the following:
“In Taleb’s universe, the fieriest circle of hell is reserved for bankers and neoconservatives. ‘The best thing that could happen to society is the bankruptcy of Goldman Sachs,’ he tells me. ‘Banking is rent-seeking of industrial proportions.’ Taleb, who became rich as a derivatives trader, is not a foe of capitalism but of ‘cronyism’. ‘If you’re taking risks, God bless you. This is why I accept inequality. I’ve seen people go from trader to cab driver and back again.’“
Banks are a prominent example of the risk-shifting phenomenon. First of all, banking institutions are not required to hold much capital against their assets. In fact, recently banks have had average equity of less than 6% of assets. That’s much higher than during the financial crisis of ten years ago, but it is still rather thin and hardly represents much “skin in the game”.
It should come as no surprise that a bank’s assets are funded largely by account balances held by depositors (liabilities), and not by equity capital. But your bank balance is not kept as cash in the vault. Instead, it is loaned out to the bank’s credit clients or used to purchase securities. This is facilitated by “fractional reserve banking”, whereby banks need only keep a fraction of their depositors’ money on hand as cash (or in their own reserve deposit accounts with the Federal Reserve). This generally works well on a day-to-day basis because depositors seldom ask to redeem more than a small fraction of their money on a given day.
Reserve requirements are set by the Federal Reserve and range from 0-10%, depending on the size of a banks’ deposit account balances. At the upper figure, a dollar of new cash deposits would allow a bank to extend new loans of up to $0.90. This legal practice divides many in the economics profession. Some believe it represents fraud rather than sound banking. This article by Frank Hollenbeck at the Mises Canada web site states that it is improper for a bank to lend a depositor’s money to others:
“Suppose you lived in the 18th century and had 100 ounces of gold. It’s heavy and you do not live in a safe neighborhood, so you decide to bring it to a goldsmith for safekeeping. In exchange for this gold, the goldsmith gives you ten tickets where eachis clearly marked as claims against 10 ounces. …
… Quickly the goldsmith realizes there is an easy, fraudulent, way to get rich: just lend out the gold to someone else by creating another 10 tickets. Since the tickets are rarelyredeemed, the goldsmith figures he can run this scam for a very long time. Of course, it is not his gold, but since it is in his vault, he can act as though it is his money to use. This is fractional reserve banking with a voluntary reserve requirement of 50%. Today, modern US banks have a reserve requirement of between 0% and 10%. This is also how the banking systemcan create money out of thin air, or basically counterfeit money, and steal the purchasing power from others without actually having to produce real goods and services.”
Another aspect of the argument against fractional reserves is that it creates economic instability, fueling booms and busts as the quantity of money in circulation sometimes exceeds or falls short of the needs of the public. Many authorities have taken a negative view of fractional reserve banking through the years: Irving Fisher, Milton Friedman, John Cochrane, Ralph Musgrave, and Laurence Kotlikoff, to name a few prominent economists (see this recent paper by Musgrave).
In Defense of Fractional Reserves
Others have defended fractional reserves as a practice that has and would again arise in a free market environment. According to this view, depositors would accept the logic of allowing banks to lend a portion of the funds in their accounts in order to generate income, rather than charging larger fees for “storage” and administration. If the depositing public is aware of the risk and has competing choices among banks, then the argument that banks expose depositors to excessive risk via fractional reserves is moot. Fractional reserves can exist in a private money economy in which competitive pressures reward banks (and their privately circulating notes) having sound lending practices. In fact, some would say that the very idea of a 100% reserve requirement is an unacceptable government intrusion into the private relationship between banks and their customers. All of that is true.
Some have compared fractional reserve banking to the sale of insurance. Consumers buy insurance to take advantage of pooled risk, but they have no expectation of a refund unless they incur the kind of insured loss in question. Bank depositors, on the other hand, expect a return of their funds in-full. Yes, low risk is an attribute they desire, and pooling across the withdrawal needs of many depositors is one reason why banks can invest and pass a part of the return on to depositors, both in interest and reduced fees. So, despite the differing needs and expectations of their customers, there is some validity to the comparison of insurers to fractional-reserve bankers.
Amplification of Shifted Risks
Do fractional reserves allow banks to take risks without having skin in the game? Absolutely! With as little as 6% equity at risk, banks have relatively little to lose relative to depositors. Yes, banks pay the FDIC to insure deposits, and premiums are higher for riskier banks. However, not all deposits are insured by the FDIC. More importantly, at the end of 2017, the entire FDIC deposit insurance fund was about 0.7% of commercial bank assets. One big bank failure would wipe it out, or a few hundred small ones. That’s well within the realm of possibility and historical experience. So, where does that leave depositors? Their skin is very much in the game, and the game is about the risks taken by banks in investing depositors’ funds.
We now live in the era of “too-big-to-fail” (TBTF), whereby large banks (and sometimes industrial firms) are viewed as so “systemically important” that they cannot be allowed to fail. Taxpayers must bail them out in the event they become insolvent. Thus, taxpayers have skin in the game. Banks collect rents to the extent that their returns exceed those commensurate with the risks for which they are actually “on the hook”.
Another avenue through which banks off-load risk is the extent to which Fannie Mae and Freddie Mac are still presumed to have the federal government’s implicit guarantee against default on the mortgage debt they purchase from banks. That is beyond the scope of the present discussion, however. And I have not discussed the role of large investment banks in the capital markets. That’s a whole other dimension of the story. This article by Guatam Mukunda in the Harvard Business Review provides a perspective on rent seeking in investment banking.
The combination of deposit insurance, TBTF and other risk-insulating subsidies, layered on top of a fractional reserve banking system, places banks into Taleb’s “fieriest circle of hell”. These factors blunt bank incentives to manage risk effectively as well as consumer incentives to conduct adequate due diligence in their banking relationships. It means that risk is not priced properly, because banks are likely to ignore risks from which they are shielded. Therefore, banks may allocate resources into excessively risky uses. The consequences for depositors and taxpayers can be dramatic.
Fractional reserves are not “fraud” in the sense that the system has unsuspecting victims. Anyone who has watched “It’s a Wonderful Life” knows that banks lend your deposits to others. But fractional reserves magnify the risk-mitigating privileges conferred upon the banking industry by government through various mechanisms. This “risk-cleansing” is converted to rents and collected by banks for their shareholders, but the risks are still borne by society. To the extent that fractional reserves create instability, deposit insurance is viewed as a necessity, but banks should pay a market premium to an insurer to cover the actual risk inherent in the system. Too-big-to-fail should end, as should the implicit subsidy collected by banks through the government-sponsored enterprises.