why let "customers" off the hook?
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.
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.
Comments
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.
I agree that if my suggestion of dismantling deposit guarantees were carried out, there would be massive economic disruptions. I am not suggesting we just go "cold turkey". However, I do believe that any solutions we come up with to "improve" our financial system need to include the principal of injecting a degree of risk for the banking customer (be they consumers with traditional banks or hedge funds with investment banks). Just letting customers continue to believe that they are always safe, and need take no responsibility in choosing sound banks, is no solution at all, and will only lead to greater problems down the road.
Maybe we could have some kind of system where customers will automatically get a certain percentage loss of their savings/contracts if their bank goes under? That would be better than a flat guarantee of total indemnity.
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!).
Here are some resources consumers can use to find out the health of their banks. One really rough guide is to look at the ranking for the institutions offering the highest CD rates. There tends to be a high correlation between the health of a given lender and the interest rates they offer to savers. For example, it shouldn't be any surprise the WaMu and Countrywide offer some of the best interest rates right now.
http://www.TheStreet.com/tsc/ratings/screener.html
http://www.bankrate.com/brm/safesound/ss_home.asp
These resources aside, if we had a system where customers suffered when the lender went bust, there would be much more demand for better (and easier to understand) ratings and financial reports. Those institutions that published opaque financials simply find it hard to even get any business at all. The problem today is that there simply isn't any incentive for banks to be prudent and forthright (i.e. because the customers don't care, only looking for the best interest rates or deals).