melanoman: (Default)
[personal profile] melanoman
This was inspired by a recent HuffingtonPost article that tried to explain what was wrong with banking policy since deregulation took hold.

This is a well considered article, but it doesn't quite bridge the gap between the financial dialects and the popular audience in a few places. A few examples can help immensely with this.

When a person buys stock in a company or other venture, this is an equity investment­. They get a share of the proceeds in the form of dividend, and may be given some degree of control of the company.

When a person makes a Certificat­e of Deposit (a "CD"), they hold a debt for the bank.

Let's say two banks each spin off a subdivisio­n to issue credit cards. If the division is funded with equity (such as by selling stock), and the division is a disaster, the stock holders lose their money. If the division is backed by CDs, then the cost of the disaster is transferre­d to safety nets like the FDIC.

SaneBank and CrazyBank, run their credit cards differentl­y. SaneBank checks credit history carefully and limits their credit to people that aren't so risky. CrazyBank barely checks to see that the card holder is even a real person.

Obviously CrazyBank is going to be a disaster. If people bought stock in CrazyBank, and there are no bail-outs to confuse things, they will lose their investment­. If CrazyBank was funded with debt, then they get to pawn their costs off on the public by collecting on deposit insurance. So it is in the public interest not to allow CrazyBank to do this.

This is where regulation comes in. We can set banking policy to require that anyone who funds things with debt must run things more safely. Stock buyers will stop investing in CrazyBank because they don't want to lose their money. And the regulation­s will prevent CrazyBank from acting crazy if they use debt to finance their operation. (assuming the regulation­s are well made and enforced).

At this point some spokescrit­ter for CrazyBank will start jumping up and down to say the these regulation will cost them money. That is true, they will no longer be able to rely on the deposit insurance money. But think of where that money they want came from. It came from SaneBank. When we require bank to join an insurance scheme without adding the appropriat­e regulation­s, what we are really doing is allowing CrazyBank to take money away from SaneBank.

At that point SaneBank has the incentive to gets its own share of the insurance money (or bailout money), which means they need to start acting crazy. This all goes back to the regulation structure. If we force CrazyBank to behave well or else kick them out of the insurance group, then Crazy bank needs to act more sane. If we don't, then SaneBank starts to act more crazy.

Until the government steps back in and takes its regulatory responsibi­lity more seriously, we are going to get more and more crazy behavior, which isn't good for anybody.
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