Back to Banking Basics


The two biggest economic disasters in this generation are caused by a banking crisis — the Great Depression of 1930s, and the current Great Recession since 2008. Although still recovering from the latter, we seem to have forgotten the lessons of the terrible financial meltdown. Most people now complain about high unemployment and huge bank bailouts without even mentioning the reasons that caused them. This prevents real banking reform from being done in order to avoid a similar catastrophe in the future.

What banking reform? We must go back to the basics because the banks have lost their compass in the money chase. What are banks for in the first place? The banks function as financing agents using the depositors’ money to lend it to various kinds of business. This increases employment opportunities and grows the economy. The bank makes a good profit because it borrows low (currently near 0% for deposit interest in US) and lends high (ranging from 3% for home mortgage to 20% for credit card). What do the depositors want? They want safety and service. Most importantly, they want their deposit money to be available whenever in need. The banks must value this public trust. It is this fiduciary duty that is fundamental to the banking business. This trust is so important to public confidence that the government must protect the depositors in the form of federal deposit insurance (limited to $200,000 in the US for each account) by charging insurance fees to the banks.

What if a bank gambles with your deposit, and collapses as a consequence? You cannot pay your bills and your lifetime savings will be wiped out. That is the most terrible financial loss that can happen to an innocent depositor. The sad thing is that no banking executives are held responsible when a bank fails. They are clever enough to blame their failed ventures in the stock market and other speculative markets for the loss of depositors’ money. Then the government is forced to take over the bank and liquidate its assets to pay back the depositors. Most likely, there will not be enough money left, and the government winds up footing the bill. This is the so-called privatization of profit and socialization of loss, meaning the top banking executives get away with the profit and the taxpayers pay for the loss. So you see the current system works like a scam and is grossly unfair to common people like you and me.

The situation was one of panic when a number of the nation’s top banks began to run out of cash in the fall of 2008. The American economy was on the brink of collapse. The federal government stepped in with a bailout of $750 billion to avert the calamity. Now people still complain about the huge bailout instead of what caused the bailout. Can we let the big banks fail without worrying about the consequences? Big banks cannot be allowed to fail because of the domino effect leading to a total economic collapse all over the world. The logical solution then is how to prevent big banks from failing.

It sounds very complicated if we lose sight of the banking fundamentals. Going back to the basics, we need only three conditions to be enforced by the government: First, banks cannot gamble with depositors’ money. Second, banks cannot become too big, the logic being that too big to fail means too big to exist as a commercial enterprise. Third, banks should be transparent with regard to their business dealings and investments.

The Glass-Steagall Banking Act of 1933 was meant to enforce the first condition. It forbids the banks from using depositors’ money to play in the speculative markets such as stocks and shares, securities, foreign currencies, and commodities. It separates the banks into two groups: the regular commercial banks and the investment banks. The former takes regular deposits from the public. The government backs them up with deposit insurance to guard against possible failure. The latter can only accept money from willing investors who can afford to take risks. The government does not guarantee them against failure because the investors know full well that they will absorb the financial loss if their investments go sour. But something changed in 1999.

In 1999, the US Congress voted to repeal the Glass-Steagall Act, and replace it with the Gramm-Leach-Bliley Act. Due to intense lobby (or bribery?) by the banking sector, the distinction between commercial and investment banks was torn down. The commercial banks can now trade in the speculative markets. The investment banks and brokerage companies are allowed to attract deposits by opening checking or retirement accounts like regular commercial banks. The consequence is that the banks ran wild in speculative dealings, creating a housing bubble that eventually burst in 2008.

Re-instating the Glass-Steagall Act will enforce the first condition for banks as it had done since 1933. This law will also enforce the second condition by separating the real commercial investments from the speculative investments. In other words, all commercial banks will be forced to divorce their speculative investment branches, making them much smaller without the inflated prices of their speculative investments. As for investment banks, they will be forbidden to do regular commercial banking to attract innocent depositors. Their investments will have no government insurance backing. Should they fail, the investors should willingly absorb all the losses. The innocent depositors, that is the general public, will thus be insulated against the fallout.

The third condition is the hardest to enforce. Due to the tremendous amounts of money involved in the banking business, scam, bribery, and money laundering are daily occurrences that we seldom see. How can we expect the banks to be transparent about their shadowy dealings? Will they voluntarily expose their own secret deals? We should not be surprised to see the banks trying to bribe top government officials to make laws in their favor, or not to enforce existing tough laws. What can be done? Not much I’m afraid. A law forbidding greed and bribery is not enforceable by people of lesser conscience. In spite of all the imperfections, doing the basic thing will go a long way. That means re-instating a simple law such as the Glass-Steagall Act to forbid the commercial banks from gambling in the speculative markets with the general public’s deposit money.

April 2013

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This entry was posted in 21st Century, Business/Investment, Economics/Politics, Inspiration. Bookmark the permalink.

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