Seattle Bubble Forum Archive

One characteristic of most bail-out proposals is that the "customers" should be made whole when the financial institutions they do business with go bust. Sure, the Bear Stearns shareholders might take a big hit, but let's make sure that all those folks doing business can rest assured that the money they deposited with Bear is safe, and that Bear's derivative contract obligations will be honoured in full.

But why should the customers of financial firms get off so easily? After all, it is the refusal of customers to take any responsibility for picking sound companies to do business with that exacerbates the problems in global finance. Instead of selecting a bank, or financial firm, which has very conservative reserves and balance sheets, customers seek out those firms who offer the best interest rates, lowest fees, or a willingness to be counterparty to the riskiest forms of contracts.

This natural flow of customers to the riskiest financial institutions creates perverse incentives for the entire industry: if you don't compete with the most reckless of your banking competitors all your customers will leave.

This is a similar phenomena to the situation where consumers flock to the banks with the best interest rates and service for their savings accounts. Since the government guarantees your deposits anyway (as long as they are under a certain amount) then why should anyone care whether the lenders offering the best rates have the worst balance sheets?

Until the customers have suffered real pain, and seen their derivatives contracts go "poof" as their counterparties go into recievership, we will never get our financial system on a sound footing. It's the customer who needs to feel the fear of God, for the risk of losing their money, so they will have the incentive to start looking at other factors when choosing who to do business with.

I think this is a really good question. We worry about moral hazard, and to some degree, even the FDIC is a moral hazard. Let's create a strawman of your suggestion and see how it would hold up. Also, let's assume for the time being that banking itself is a necessary evil.

To serve their purpose - placing a time cost on money so those who need it now can gain access to it - a bank must always owe more money to depositors than it currently has on hand. Even if a bank keeps 50% of all deposits as cash in it's vaults, it is still possible that a bank run could take down that institution. One thing (among many) which is proven to encourage bank runs is the belief of depositors that the bank will not pay them back. The law of unintended consequences is that I think your suggestion would only further destablize the economy since any cash I don't hide under a mattress is at risk.

While I disagree with your ultra-generic suggestion, I do agree that this system encourages a race to the bottom. It also is confusing. It's probably unreasonable to expect Joe Nobody to realize that Bear Sterns is not a real bank, and thus the money they have in it is not FDIC insured. The problem is that banking is really a public good on some levels. Forget about houses and cars for an instance. It helps the public that new businesses are able to get lines of credit so they can grow and create jobs. These lines of credit have to come from somewhere and banks are a great way to amortize the total risk in the system.

That's a great thought, Sniglet, but how many of us really know the true financial health of any institution or business that we are putting our $ into, and how does Joe Consumer go about finding out the skinny?

I'm sure that thousands of Enron employees thought that they were just fine with their 401Ks packed with company stock as well--who knew?

By the time you find out that an institution is in trouble, it's usually too late. And yes, I know how to research a company. Back in high school I used to go to the library and look up the financial information of companies in actual books, but I was assuming that the data contained therein was accurate and complete. Recent history has proven that one can't assume this anymore (thanks deregulation!).