Wednesday, February 24, 2016

Paying Banks to Risk Deposits

"And I hate to tell you this, but it's a bankrupt business model. It won't work. It's systemic, it's malignant, and it's cancer."
--Gordon Gekko (Wall Street: Money Never Sleeps)

If a bank was merely a 'money warehouse,' i.e., a place where you stored your money to keep it safe and accessible, then you would pay the warehouser a fee to do so. In exchange for the fee, the warehouser would give a receipt or claim check that would allow you to withdraw your funds on demand.

In fact, this was the original function of banks. They provided a secure environment for valuables and were paid to do so.

But safe storage is not the primary function of banks today. Instead, banks are leveraged lending machines, pyramiding deposits many times over to increase return on investment. Ironically, it is a bankrupt business model in that the leverage employed prohibits all funds to be returned to depositors at the same time (which is what precipitates bank runs).

In unhampered markets, there is nothing inherently illegal about this approach. However, depositors (who are really lenders) must understand the risks involved and be prepared for the possibility that their loans to banks may not be paid back.

Naturally, lenders to banks will rightly want to be appropriately compensated for such risk. The greater the risk, the greater the 'interest' paid by banks to depositors in order to attract capital. This is why banks should pay you for the privilege of taking in (and lending) your money. In a free market, banks could fail and you would not get your deposits back.

Of course, the modern day 'innovation' of deposit insurance backed by the government has distorted the risk assessment capabilities of depositors immensely. When the FDIC sign hangs on the door, depositors give nary a thought about how much risk their banking institution is taking with their funds. btw, the FDIC itself happens to be chronically underfunded in the event of widespread bank failures.

Because depositors have basically checked their brains at the door, central bankers think that NIRP has a chance of succeeding. The proposition is that depositors will be willing to pay banks a fee so that the banks can borrow deposits for leveraged lending purposes.

Absurd, I know, but with financial literacy so low, policymakers have reason to believe that people do not understand that they are lenders to banks who should demand compensation for putting their deposits at risk.

No comments: