“The FDIC is taking this unprecedented action because we have faith in our economy, our country, and our banking system,” said FDIC Chairman Sheila C. Bair. “The overwhelming majority of banks are strong, safe, and sound. A lack of confidence is driving the current turmoil, and it is this lack of confidence that these guarantees are designed to address.”
What brought us here? In light of the current financial situation, moral hazard and asymmetric information as inherent factors of the banking model, have been key issues in the debate over how the government should respond to financial distress. It is certainly an interesting time to analyze the government initiatives, argue their viability, analyze the root causes of past inefficiencies, and investigate relevant solutions.
As financial markets have been functioning erratically lately, it is necessary to examine what brought about government intervention. Why would a perfectly functioning depository institution in 2007and prior years will be compelled to receive bailout funds this year and last’s? To understand this, we must first discuss what prompts individuals to act and choose a certain outcome over another. In addition, we can infer that there are two types of individuals- risk averse and risk preferring. The risk averse one desires to diversify. As such, man over the years has found ways to process risk, absorb it, and shift it. Likewise, we will attempt to discuss the natural emergence of banks as an essential component of a society. The banking model is a result of a collective aspiration to efficiently utilize scarce resources. Man needs a venue to park his money in a secure location and banks found ways to profit from it through lending. In order for markets to function efficiently, financial intermediaries must exist and based on empirical evidence, these banks’ existence present a positive signal, as they supply a special service that no other entity can adequately provide.
The intrinsic special nature of banks is prone to excessive abuse as managers enjoy a concentration of economic power. To remedy this, there needs to be a stabilizing influence, thus the creation of the central bank as the lender of last resort. The introduction of the Federal Reserve System, as the US’ central bank, established a type of moral hazard as member banks felt they have a safety net. To counter this, reserve requirements are imposed to limit the amount of money loaned compared to its cash assets. As fractional reserve banking is intrinsically susceptible to failure, over the years certain regulations have been introduced including the creation of the Federal Deposit Insurance Corporation (FDIC) in 1933 to restore public confidence in the nation’s banking system. According to the FDIC official website, this government entity “insures deposits at the nation’s 8,451 banks and savings associations and it promotes the safety and soundness of these institutions by identifying, monitoring and addressing risks to which they are exposed. The FDIC receives no federal tax dollars – insured financial institutions fund its operations”. Now, if this is so, why is the banking system in worse shape since the Great Depression?
As we have seen with the housing bubble of 2007, the subprime mortgage crisis exposed the realities inherent in the banking structure. It created a destructive impact to the financial system and the economy in general. The types of residential mortgage contracts originated in the last decade, where programs involving personal statement of assets and income without verification were in abundance and unregulated, uncovered the concept of asymmetric information. In this scenario, the borrower knew the truth, in consequence has better information over the loan officer. As such, is aware of his or her true capacity to repay the loan. However, this doesn’t seem to bother the system, as banks and brokers continued to originate loans, considering that they are not lending their own money. They shifted risk to lenders or other banks, who sold mortgages soon after underwriting them. These mortgages were then sold to investment banks, who then packaged them into mortgage backed securities or MBS. The MBS were bought by investors in the capital markets, who then hedged against the risk of default and prepayment. Thus, continuation of risk transfer created a type of moral hazard. In this scenario, the banks and other non depository institutions do not bear the full consequences of their actions. They acted less carefully, leaving the lender of last resort with the responsibility for potential losses. As such, it is now the Federal Reserve, in the form of tax payer funds, who assumed the ultimate risk.
*If you would like a copy of the full study (11 pages), please email me at info@chicagoprimeproperties.com*
This entry was posted
on Friday, May 8th, 2009 at 9:39 am and is filed under Market Updates, Resources.
You can follow any responses to this entry through the RSS 2.0 feed.
Crains