Banks are not private

Banks are not private businesses.

Yes, of course, they do pretend to be. They are listed on stock markets. They take the organizational form of a private business. Their profits are definitely privatized.

But their risk is borne almost entirely by the state. Beyond a small sliver of equity and bonds sits a vast ocean of "deposits" that the state guarantees, explicitly via "deposit insurance", tacitly far beyond that.

"Deposit insurance" itself is a pretense. Recall that the first thing FDIC did during the 2008 financial crisis was more than double its insurance limit from $100,000 to $250,000. What kind of insurance company increases the limit of the insurance it provides at just the moment claims become likely to be made? What kind of insurance company lets you multiply your insuredness for free if you perform bureaucratic busywork that does not in anyway mitigate the underlying risk, like split your deposits between an account in your name and a joint account, or form a trust that's still yours unless you die?

FDIC is not "limited deposit insurance". When it was founded, perhaps it was intended to be that. But by the early 1970s, as the strict prudential regulation that emerged during the Great Depression was slowly whittled away, anyone paying attention came to understand that the state's role in banking goes far beyond an insurance product, maybe on slightly subsidized terms. With an insurance company, it's usually a bit of a struggle to get claims paid. The companies are trying to minimize payouts. With FDIC, it is an extraordinary event when even notionally uninsured depositors are not made whole. It does occasionally happen! But it is the exception, not the rule. It results from the sin of keeping deposits beyond FDIC's notional limit in a bank so minor and insignificant that its customers can be sacrificed to the project of maintaining appearances. It must appear that FDIC is an insurance company with a statutory obligation to minimize costs. It must appear that banks are private companies that are required, as many businesses are, to purchase certain insurance products in order to protect customers or workers.

Whether the resolution of a bank — or, more usually, a cluster of banks, since bank failures are not independent events — will ultimately be cheap or costly to "the taxpayer" depends almost entirely upon regulation and supervision prior to the resolution. FDIC (and the Treasury, and Fed) can play various games to limit the impact of resolution on the Deposit Insurance Fund, like levying fees to other banks that will be passed along to taxpayers in their role of bank customers (or that would be, if bank profits were disciplined by competition). But the cost of a bank resolution will always be the size of the hole in the banks' balance sheet that supervisors have allowed to emerge before resolving the bank. All FDIC can do is allocate (or obfuscate) the cost.

That said, bank resolutions needn't be costly! When supervisors do their job — when the state uses the tools at its disposal to aggressively manage this risk of banks that the state almost entirely bears — banks are prevented from taking risks that will make the bankers rich if things work out, but leave a crater in a balance sheet they walk away from if things don't work out. When supervisors actually do take "prompt corrective action", they can prevent balance sheet holes from growing very large, and so minimize the cost of resolving a bank.

Bank resolutions needn't be costly, though of course often they are. The bank failures attending the 2008 financial crisis and the 1980s S&L crisis were not cheap.

But people spend far too much energy worrying about the cost of bank failures, and far too little worrying about the cost of bank survival.

Banks are not private businesses. Their risk is borne almost entirely by the state, so the state tilts the playing field to ensure that overt, embarrassing, disruptive bank failures are suppressed. No one objects (except the bankers) when this takes the form of supervision and prudential regulation. But the most costly forms of state support take the form of subsidies that the state can pretend are not "taxpayer funded", but that impose quiet costs on the public anyway. Do you remember when the Fed retroactively rewrote millions of lending contracts so that banks could charge more interest and recapitalize? Do you remember when the nation debt doubled in less than four years, precisely so that large banks would not have to be resolved? Yes, Virginia. Bank failures, actually, are much less expensive than the things we do to fill holes in bank balance sheets so we need never acknowledge their failures.

Apropos nothing, check out this Bank Term Funding Program! Valued at par. 1

Meanwhile, since we pretend banks are private businesses, we let shareholders and managers siphon off wealth while banks take risks on behalf of the state, and then again as they skim from the opaque subsidies the state pours into them when things go sour.

It is a good thing, not a bad thing, that the risk of aggregate investment is ultimately borne by the state. I am sometimes asked whether I really believe that our choices are to tolerate something on the verge of fraud or revert to goat-herding. The answer is no, I don't believe that. Even though historically private bank finance emerges — very productively! — at the edge of fraud, we now have states that can overtly undertake investment risks on our collective behalf that we as individuals would not consent to take with our own resources. The state already is the bank. What's left is to acknowledge that and, importantly, to devise an institutional structure for state-backed development finance that is not so obfuscated and corrupt and shell-gamish as contemporary banking, but that also avoids the pathologies of politicized lending.

Once upon a time, I might have been persuaded that it's good that banking camouflages as private finance while it covertly mobilizes the resources of the state. The theory is that it's much better to have investment mobilized on commercial terms than on political terms, and the pretextual privateness of contemporary banking permits that. You don't want a world in which state resources are allocated based on political connectedness or populist fads rather than investment quality.

The proof is in the pudding, though. The contemporary "private" financial system is shit. It can mobilize resources stupidly — secured against collateral like real-estate, or against least-common-denominator "hard information" like credit scores. But it no longer performs its most essential task: ferreting out and funding good uncollateralized loans. It creates rivers of financial flows from the poor and disorganized to the rich and well-connected. It has profitably, but contrary to domestic public interest, underwritten the near total offshoring of critical industrial capabilities in ways that overtly public finance, whatever else its flaws, would never have allowed. It finances consolidation of industry, and helps organize shareholders into tacit cartels. Despite its privateness and supposed commercial orientation, contemprary finance is hardly immune to cronyism.

For all the obvious pathologies of our politics — in part because those pathologies are obvious and public — I think we would be better off reorganizing finance, disentangling deposits and payments entirely from risk investment, ensuring credit availability by having the state explicitly support investment funds dedicated to forms of economic development we decide are prosocial.

Of course there will be scandals. It is an institutional reality that private sector business aggressively markets itself as virtuous, despite its unhidden thirst to maximize the rents it can extract, while the public sector is subject to eternal scrutiny, under which every failure to live up to an ideal of public spiritedness is treated as discrediting of the entire enterprise. But the public sector succeeds at least partially at virtues that the private sector does not even pretend to attempt. The private sector is precisely in the business of doing the self-interested things that in the public sector get called corruption. It's just not labeled corrupt, because treating aggressively in ones own self-interest is what's expected!

A better financial system would include investment funds whose private managers, like contemporary banks, enjoy outsized gains in exchange for exposure to first loss on state-financed investment. But there would be no prevarification about where the money is coming from. It is coming from the state. It is a mobilization of our collective risk-bearing capacity, towards ends that the broad public supports. The composition of our aggregate investment portfolio — the most important edifice that we all collectively construct — would not be pawned off on anonymous market forces. It is the responsibility of the democratic state, however imperfect our democracy remains.

See also Robert Hockett and Saule Omarova

  1. BTFP should be understood as a bet by the Fed that inflation will subside and they can soon revert to the last decade's very low interest rates. This would create capital gains that will help offset losses of banks that reached for yield — but too little yield — buying longer-term, low risk, bonds. (Banks that reached for actual profits by making high-quality unsecured loans are fine, despite rising rates, because the credit spread in those loans can cover this moment's high cost of short-term finance. They'll be at risk, though, if an economic downturn creates a wave of failures to repay.)