What Exactly is the Comparative Advantage of Banks?

by Mike Kimel

What Exactly is the Comparative Advantage of Banks?
Cross posted at the Presimetrics blog.

What exactly is the comparative advantage of banks? When the bank bail-outs began, I noted that bailing out banks makes no sense whatsoever. The focus should be on a well-functioning financial system, and not on the survival of existing banks. Given the periodic “need” the industry collectively seems to experience for bail-outs, it is clear that something is wrong; a well-functioning financial system should not require regular, large-scale bail-outs.

Here is the first of two back-to-back posts I wrote in 2008:

The Cactus Bail-Out Plan: Cheaper, Better, Faster

One of the goals of Paulson’s Bad Joke seems to be to deal with “counterparty risk.” That is, if Bank A can’t find a greater fool to buy its garbage, it will have trouble paying back Bank B. It would be cheaper to simply tell Bank B to collect what it can from Bank A’s bankruptcy proceedings, and cut them a check for what’s left to eliminate the counterparty risk. Whether helping Bank B makes any sense or not, at least this plan would cost the taxpayer much less, as it wouldn’t include the expense of keeping Bank A afloat. So if we’re going to have a costly bail-out, let’s at least focus only on bailing out the “good banks” and let the “bad banks” die.

The problem with the approach I laid out is that the process can drag on. But fortunately, if we’ve learned anything from the Bush administration, its that rushing along at breakneck speed isn’t a problem if you claim there’s some sort of national emergency. So… pass the “Banking Patriot Act.” Any bank that is in trouble must liquidate its assets immediately and pay back its creditors to the best of its ability. The government would use its $700 billion to compensate the good banks for their counterparty losses. Voila – no counterparty risk, no uncertainty in the banking system, no rewarding the bad banks, and the system operates as it should.

But… what makes the bad banks go along with this plan? Well, its simple, really. A provision of the “Banking Patriot Act” allows the government to view any communications by anyone at the bank to see if they’re in trouble. And if any bank turns out to be in trouble but did not go along with the “liquidate immediately” order – well, its executives would all be declared enemy bankers, and would be interned at Gitmo. And there would be waterboarding to find out if those enemy bankers know of other enemy bankers.

Yes, yes, I know, many of the banks have paid back the TARP money. That’s the TARP money. Nobody is compensating the government for taking toxic assets off their balance sheets, nor for the ongoing subsidies coming from being allowed to borrow at ludicrously low rates from the Fed and loaning out at higher rates to the Feds.

The second post I wrote at that point was a bit stronger:

An Immodest Proposal – End the Privileges of the Banks

Yesterday I laid out what I think is a better, cheaper, faster approach to the bank bail-out. But that assumes a bail-out is necessary. However, I think a bail-out, any bail-out, is a bad idea.

Consider the role of banks. Banks essentially store money and act as payment agents for depositors, and they loan out money to borrowers.

Now, consider the role of the Fed. The Fed essentially stores money and acts as a payment agent for the banks, and it loans out money to the banks. Put another way – the banks are just an intermediary between the Fed and public. Put even more simply – the banks are a middle-man. Now, back in the day, it was necessary to have a middle-man, someone who knew the local market, who knew the depositors and knew the borrowers, and understood whether making a given load was a good idea. There’s no way the Fed, say, could do that from Washington.

But today, things are different. First, its clear that the banks have no idea who their depositors are, and much less whether the folks borrowing have any chance at all of paying back what they borrowed. That’s self-evident from the fact we’re even debating whether to bail out much of the industry. Second, in this day and age, what information they do have and use generally comes from third parties. They aren’t any better at buying FICO scores than anyone else would be.

So the question is – how exactly do we benefit from having the banks operating as a middle-man between the rest of us and the Fed? Why not let people deposit their money with the Fed, just like banks do, and let people borrow from the discount window, just like banks (and apparently some non-banks) do? I don’t see the benefits to giving banks rights that people don’t have, but I do see plenty of cost. I see a lot of duplication of services between various banks, and I see huge salaries going to the bank executives for that duplication and for acting as middle-men… and that doesn’t even count the cost of the current bail-out. Note also – salaries at the Fed are much lower. I believe Big Bad Ben Bernanke makes about $200K, a pittance compared to the salaries received by the CEOs of a number of banks recently driven into the ground. And there ain’t no stock options at the Fed either!

So I propose letting the public bank at the Fed, just the same way banks bank at the Fed. I’m not proposing banks be made illegal – if they can find a way to operate without having a getting privileged access to the Fed, wonderful. That’s free enterprise and it should be applauded. But the current system, where banks get privileged access to the Federal Reserve is rather unfair, and its been that way since long before this mess began.

Perhaps the most salient objection some readers raised at the time to the plan put forth in the latter post was that while banks might have an account with the Fed, banks borrowing in the overnight market were borrowing from other banks, not directly from the Fed. Of course, that ignored a few details (e.g., the discount window). It also completely missed the point of what would happen over the two years that have followed the writing of that post: while the Fed took billions of dollars of “toxic assets” off the banks hands and gave them prime rib in its place, the business model for much of the banking sector can be described as “get money at a very cheap rate from one branch of government and loan it out at a higher rate to another branch of government” mentioned a few paragraphs up.

Its long past time to stop subsidizing an industry that is not sustainable. If banks do not have any demonstrable comparative advantage (other than sucking down subsidies), keeping them alive should not be a priority.

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As an aside, regular readers know I tend to like posts that involve some amount of numerical analysis. For the foreseeable future, I simply don’t have the time to do that on a regular basis. Expect more verbage and very few graphs for the foreseeable future.