Does social power mismanage banking-practice in this-or-that special instance–then let the State, which never has shown itself able to keep its own finances from sinking promptly into the slough of misfeasance, wastefulness and corruption, intervene to “supervise” or “regulate” the whole body of banking-practice, or even take it over entire.-Albert Jay Nock, 1935
Nothing irritates me more than a government-created problem that prompts cries for more government action. A great example of this is the horrible crises, fiscal and monetary, caused in Europe by socialism and central banking, respectively. George Soros and so many others respond to the European Debt Crisis with cries for greater political union and more central government control in Europe. Historical examples of government growth in the wake of government injustice include the response to bans on unionization with laws unfairly favoring unions, or the response to government-mandated segregation with laws that infringe on private property rights under the false guise of pursuing racial justice. (Want racial justice? End the Drug War.)
The latest example of this maddening phenomenon is, generally speaking, the constant demand for more regulation of the financial sector, and specifically, calls for more regulation of trading in the wake of JP Morgan’s recent losses. The fact is, like coal mining, oil drilling and nuclear power, the financial sector is one of the most highly regulated industries in the history of humanity, yet calamities that bring us to the brink of physical, financial and planetary destruction seem to be occurring in these fields at an accelerating pace.
The reality is that it takes a tremendous amount of pull and paperwork, acrobatics and access, to open a bank in this country. Once you are permitted to open a bank, you must devote massive resources to departments dedicated to meeting accounting requirements, legal requirements, regulatory requirements, employment compliance requirements and a thousand more government-required expenses on top. Because of all of these government-generated, artificial barriers to entry it is not easy to enter the banking industry to compete with large, existing banks. Perhaps paradoxically, it is the tremendous profit potential inherent in these barriers to entry that prompted the so-called robber barons to usher in the Progressive Era at the same time they spearheaded the American Imperialist Movement a hundred years ago to make sure they could maintain their dominance in industries that were quickly losing their profitability to upstarts and entrepreneurs.
Underlying all of this, the federal government has set up a fractional reserve banking system that frees depositors from assessing the health or sickness of the banks they choose to put their money in by offering federal deposit insurance. In the absence of federal deposit insurance we wouldn’t even have to outlaw fractional reserve banking–free market, private sector rating agencies or insurance companies would quickly reveal the tremendous risk that comes with pyramiding loans atop a small monetary base.
As it is now, however, depositors deposit funds in a bank and those funds are guaranteed by the federal government. The banks in turn pay depositors the interest rate commanded by such a secure deposit, which today is approximately 0%. Meanwhile, the banks take this money and lend it out in the form of mortgages or business loans or take greater risks with it through proprietary trading or investments. The banks then earn a return that reflects the fact that they are bearing risk, though this risk is not reflected in (nor deterred by) the bank’s cost of funds as it would have been in the absence of a government guarantee on deposits.
The problem is that the risk banks generate is not totally borne by the banks themselves but is partially borne by taxpayers through subsidies provided by the federal government in the form of guaranteed deposits and by TARP-type bailouts. Banks act based on the risk they actually bear, not based on the riskiness of their activities overall, so these subsidies create moral hazard, riskier behavior than otherwise would occur and larger, less-stable banks than would exist in a free market.
There would be no need to micromanage JP Morgan or any other bank in a free market. Just stop subsidizing or even allowing the fraudulent approach to fractional reserve banking inherent in our Federal Reserve system; stop giving the false sense of security inherent in an overly-regulated and government-guaranteed industry; and eliminate the huge regulatory barriers to entry that prevent competitors from weeding out reckless banks before they get too-big-to-fail, too-big-to-bail or too-big-to-manage. The free market would keep these banks in line as opposed to the highly regulated system we have now which creates unnaturally large institutions, moral hazards and popular pleas for ever more counter-productive government intervention.
Let JP Morgan’s shareholders take the hit on these losses, but give them the option to invest in banks that are proven sound by their mere survival in a free and competitive banking environment.