leverage, politics and action (predictions for the US banking system)
October 2, 2008
The banking system in the United States looks considerably worse than it did two weeks ago, as do the prospects for the American and world economies. Much of the change was predictable, but the interplay between economics, politics and psychology is becoming clearer.
The bill the U.S. Senate just passed, or something similar, looks likely to make it through the House and become law. The economics of the bill appear to be simply wrong. And when combined with politics and psychology, it looks likely that the bill will accelerate the problem rather than mitigating or even delaying the impact.
With the amount of leverage in the financial sector, though, no matter how much the bill helps the finances of the banks, it will be small relative to the web of investments that needs to be unwound to get back to a reasonable capital ratio. Under more normal circumstances, the capital infusion should lead to extra lending to consumers and business of around ten times the increase in capital (based on normal banking leverage). But these are not normal circumstances, and the first thing banks will do with additional capital is shore up their balance sheets and reduce their dependence on external funding for their operations. Since it won’t be clear who benefits and by how much, banks won’t start trusting each other as counterparties again. And since many banks won’t benefit significantly, and interbank lending won’t revive quickly, it won’t stave off bank failures — it will just change which banks fail.
Worse yet, the fact that bold action was taken and was ineffective will destroy faith in the federal government’s ability to deal with the problem. This will further reduce faith in the medium-term future of the banking system, encouraging bank runs.
What the bill will probably do is make it easier to stuff failing banks into the soon-to-be “big 5″ banks — Bank of America, JPMorgan Chase, Citibank and the newly-licensed Goldman Sachs and Morgan Stanley. The Federal Reserve and the FDIC may display efficiency and competence at consolidating failing banks into these institutions, which might provide some stability. But there will be two problem with this.
First, these banks, or at least the three existing deposit-takers, will be increasingly unhealthy underneath. (They’re probably already pretty bad.) Second, these banks will start becoming less willing to accept new failed banks into their portfolios. Goldman (definitely) and Morgan Stanley (probably) will resist from the start, accepting only the best deals. Within these five, the weakest will accept the least favorable acquisitions, because the weaker the bank the more motivated they will be by the incentives that will be provided. At least one, and probably two or maybe even three of these banks will end up needing to be rescued themselves. Such failures are likely to be messy, possibly involving days of closure to halt a run. Such a closure will really scare business and consumers, trigger a whole new wave of bank runs and failures.
This leaves two critical questions — what’s the time frame for all this, and how bad will the impact on the real economy be? My guess is that everything described above will happen within the next six months. As for the impact on the economy, that’s a discussion for another day.
