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HOW DID SALLY NUGENT MANAGE TO BANKRUPT THE BANKS?

Why the banking industry is so vulnerable to bankruptcies and what can be done
to correct this problem? Debt to assets, or leverage, ratios vary significantly
from industry to industry. They are typically under ten percent in most high
tech industries and go up to forty percent for public utilities. Average debt
ratios in the banking…

Why the banking industry is so vulnerable to bankruptcies and what can be done
to correct this problem?

Debt to assets, or leverage, ratios vary significantly from industry to
industry. They are typically under ten percent in most high tech industries and
go up to forty percent for public utilities. Average debt ratios in the banking
and financial services industry are in the fifty to seventy percent range,
however, and many banks have much higher leverage ratios.

The banking industry is unstable. Banks are regularly going bankrupt. Crises in
the banking industry have occurred in three distinct time periods during the
twentieth century—during the Great Depression of the 1930s, during the Savings
and Loan crisis of the 1980s and 1990s, and during the Great Recession from 2007
to present.

Firms attempt to minimize their total financing costs or Working Average Cost of
Capital (WACC). The component costs of capital (cost of debt and cost of equity)
are determined by investors’ perceptions of the risk and return possibilities
associated with buying debt or equity in a given company or individual.

A credit card loan has a higher interest rate than a home loan because the
credit card loan is riskier—i.e. there are no assets to seize if the money is
not paid back. Similarly, a high-risk company normally pays a higher interest
rate on its debt than a lower-risk company and increasing leverage is normally
associated with increasing risk. Due to deposit insurance, however, this isn’t
the case with banks.

Moral Hazard

The Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000
in the United States. Most of the European countries (including Cyprus) have
similar organizations that insure deposits up to 100,000 EUR. (See Deposit
Insurance.)

Since depositors believe that their bank accounts are insured by governments,
they do not generally know or care how much risk banks incur when they invest
their depositors’ money. This creates a moral hazard problem with very little
oversight by depositors of a bank’s management of their assets. Bank managers
can take a lot of risk and, if they make profits, they keep the money. If they
lose money, the taxpayers pay for the losses. In theory, this moral hazard
problem is mitigated by subordinated debt, investors with deposits over the
deposit insurance limit, and banking regulations. But these approaches are
clearly not working.

In a series of agreements called the Basel Accords, the Basel Committee on Bank
Supervision (BCBS) provides certain recommendations on banking regulations in
regards to capital risk, market risk and operational risk. The purpose of these
accords is to ensure financial institutions have enough capital to meet their
obligations. The Tier I and Tier II capital controls of the Basel Agreements are
supposed to prevent banks from taking too much risk with depositors’ assets.
Tier 1 capital consists largely of shareholders’ equity. Tier 2 capital
comprises undisclosed reserves, revaluation reserves, general provisions, hybrid
instruments and subordinated debt.

The capital ratios are:

 *   Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets
 *   Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 + Tier 2) /
   Risk-adjusted assets 
 *   Leverage ratio = Tier 1 capital / Average total consolidated assets

To be well-capitalized under federal bank regulatory definitions, a bank holding
company must have a Tier 1 capital ratio of at least six percent, a total
capital ratio of at least ten percent, and a leverage ratio of at least five
percent (Capital).

The leverage ratios allowed under the Basel agreements are far higher than the
typical leverag ratios in most industries and are far higher than would exist in
a free-market financial system. Under a free-market system, depositors would not
put their money in overly-leveraged banks and banks would be forced to decrease
their leverage ratios and behave more like mutual or money market funds. Banks
would be less likely to use short-term liabilities (deposits) to fund long-term
assets (loans).

The S&L Crisis

Massive bank leverage would not create as much instability if the money supply
was stable as in the 1800s under the gold standard. Under the current
debt-is-money system, inflation and interest rates can vary wildly from year to
year. The Savings and Loan Associations (S&Ls) made many low interest 30-year
fixed rate home loans when inflation was low in the 1960s—five percent interest
rate loans were typical. As inflation increased, the S&Ls still had these
long-term home loans on their books, but the market now demanded higher interest
rates on deposits (eighteen percent at times). The interest rates that many
savings and loans were receiving on their assets (30-year fixed rate loans) were
much lower than the interest rates the same S&Ls were paying on their
liabilities (deposits). This duration mismatch resulted in the mass insolvency
of the Savings and Loan Industry and a bailout of the S&Ls by the American tax
payers exceeding $100 billion.

The Great Recession

The banking defaults of the Great Recession (2007 to present) were also caused
by unstable interest rates combined with high leverage. The Federal Reserve
lowered rates in the early 2000s to stimulate the economy after the bursting of
the dot.com bubble. This resulted in many people borrowing money at very low
interest rates to buy homes. Then the Federal Reserve raised interest rates and
many people were no longer able to make their home payments. Again the result
was massive bank insolvency and a substantial decrease in home values. Another
huge taxpayer -funded bailout of the banking system followed, and the Federal
Reserve has been printing money ever since, trying to stimulate the economy in
the wake of yet another bubble it created.  The disbursements associated with
placing into conservatorship government sponsored enterprises Fannie
Mae and Freddie Mac by the U.S. Treasury, the Troubled Asset Relief Program
(TARP), and the Federal Reserve’s Maiden Lane Transactions are probably around
$400 billion. How much of these disbursements will be paid back is currently
unclear.

During the recent crises in Cyprus, proposals were seriously considered to
ignore the 100,000 EUR deposit insurance and seize a fraction of even small
depositors’ money. Most depositors lost access to their accounts for over a week
and large depositors are still likely to lose a large fraction of their assets.
This crisis has made some depositors more likely to pay attention to the
solvency of their banks, but most depositors still believe that deposit
insurance will cover any possible losses. If banks are to become more stable,
the amount of equity relative to debt in the banking system must be drastically
increased to something resembling what it would be without government deposit
insurance, central bank subsidies, and treasury bailouts. Given the lobbying
power of bankers in Washington, DC and around the word, such is unlikely to
occur. The boom-bust cycle of banking bubbles followed by banking crises will
most surely continue.


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