Finance needs to be a focus

In 2008, the U.S. banking system was ranked 40th in the world in terms of health by the World Economic Forum. Britain followed at 44th. Guess who was ranked number one, with the healthiest banking system?

Canada. Surprised? You shouldn’t be. Canada is the only industrialized nation that hasn’t faced a single bank failure, calls for bailouts or government intervention in the financial or mortgage sectors.

The biggest difference between Canada and the U.S.? Our banks tend to be leveraged at 26 to one. Canadian banks averaged 18 to one. In other words, American banks were permitted to finance investments with a much higher proportion of borrowed funds; in fact, for every $1 they held in assets, they had $26 in debt (versus $18 in debt per dollar of asset in Canada). When Lehman Brothers went down, its leverage was approximately 30 to one.

Of course, there was a time when America’s own financial system was very stable. It’s stability rested on deposit insurance, which was created by the Glass–Steagall Act of 1933 under Franklin Roosevelt and eliminated the threat of bank runs, and strict regulation of bank balance sheets, including both restrictions on high-risk lending and limits on leverage. 

But a funny thing happened on the way to the Great Recession. “Shadow banks,” or institutions allowed to carry out banking functions but able to avoid strict regulation and safety nets (Lehman is a prime example), mushroomed.

According to New York Times columnist and Nobel economist Paul Krugman, “many businesses began parking their cash, not in bank deposits, but in ‘repo’ — overnight loans to the likes of Lehman Brothers.

Unfortunately, repo wasn’t protected and regulated like old-fashioned banking, so it was vulnerable to a pre-1930s-type crisis of confidence. And that, in a nutshell, is what went wrong in 2007-2008.”

The financial reform bill proposed by Senator Chris Dodd of Connecticut does a satisfactory job of addressing “shadow banks” by extending current bank regulatory power to those institutions. It places far too much importance and responsibility on financial regulators, however.

In his column in Newsweek, Ezra Klein points out that FDR’s response to bank runs was not to create a Commission on Bank Runs and have regulators monitor banks and then step in to insure their deposits when they appeared to be in trouble. Instead, he insured all consumer deposits, regardless of whether the chairman of the Federal Reserve stepped in to act or not. “If you want proof of how well it worked,” suggests Klein, “ask yourself this: did you line up outside your bank to close your account after Lehman collapsed?”

Dodd’s bill calls for a Financial Stability Oversight Council, made up of the chairman of the Federal Reserve, the Treasury secretary, the comptroller of the currency and the heads of five other federal agencies to set rules and regulations.

Recalling who likely would have been on that council when the most irresponsible lending was taking place in 2005, this staff would feel much more comfortable with a bill such as that proposed by Rep. Barney Frank. His bill sets capital requirements at a leverage of 15 to one rather than leaving the details up to a regulator.

Do you really trust that when a future bank is in trouble, a regulator will step in against lobbyists, shareholders, legislators, bank executives and the like to impose unpopular regulations? We, for one, would much rather have blanket rules that apply to everyone, much like deposit insurance.