Banks - Bane or Blessing?

 

One month after its launch, the “Occupy Movement” protests spread to approximately 900 cities worldwide, reported The Guardian on Monday, 17th October (Addley). The pace of its growth is astonishing. Demanding improvements of the banking sector, the so-called “Occupy Wall Street” protests started small in September with “less than a dozen college students,” (Dobnik) reported the economic journal Bloomberg BusinessWeek on the 2^nd of October, 2011. The protest grew exponentially: in a single day, the number of protestors worldwide reached 70,000. (Dobnik).

 

What the protest seems to say is that there is increasing uncertainty regarding what the banking sector’s purpose is in our modern society. “The bottom line is the feeling that the financial industries here on Wall Street have caused the economic problems [such as the financial crisis in 2008], and they're not contributing their fair share to solving them,”(Dobnik) a protestor Denise Martinez reported to BusinessWeek. The financial crisis of 2008 showed that the banking sector has weaknesses. Given the Greek debt crisis and general uncertainty in the economy, managing a bank is a difficult endeavor. But the question remains whether all the “Occupy Wall Street” protestors’ criticism is justified. Are bank managers solely responsible for the banking failure? Do we need the banks in our economy?

The banking sector’s image has not always been this poor, and according to Muhammad Yunus, it is key to our economy. In 2006, the Bengali Bank founder Muhammad Yunus received the Nobel Peace Prize, because his bank helped the Bengali to obtain microcredits. In the book “13 Bankers,” the economist Simon Johnson explains that banks have the important role of not only processing payments, but also in using money that is saved in one sector of the economy for productive investments in another part. 

Consider a start-up company that urgently needs to borrow money in order to purchase machinery that it needs to produce a good. Even if the product promises large revenue, the company will not find a private direct lender of money. This is because a normal income family wants to deposit savings for a shorter time than needed, the sum will be smaller than needed and the risk of default might be to high for a private investor. A lecturer of financial studies at Bangor Business School, Wales, Barbara Casu, explains that banks have therefore the purpose of size, maturity, and risk transformation to turn deposits into investments. The American Banker Association, for example, estimates that at this moment banks have more than $620 billion in smaller business loans and $5 trillion in outstanding mortgage loans. Much of the wealth that the United States accumulated would have been impossible without the banking sector.

 

Assumptions that we would not need the banking system are unjustified.

So where are its flaws?  To fulfill all its responsibilities, the banks have developed a very wide array of financial products or instruments. Today, investment banks trade and underwrite securities (which include stocks, that is ownership of a company, and bonds, a contract to repay a loan) on behalf of clients and engage in asset management of customers (Casu). Depending on the product, purchase of the product can be very risky or valuable, as further explained in the documentary Inside the Meltdown by the television program Frontline. One of the causes of the financial crisis 2008 was that investment banks had tied mortgage loans together and transformed them into a security. These were secured by the banks and costumers could purchase them like  a stock share. However, when owners of houses could not pay back the mortgage loan, they became worthless. This is called the burst of the real estate bubble. And the mortgage loan -securities gained later the nickname of “toxic wastes”  (Frontline).

CNN journalist Tami Luhby casts real estate agencies as also responsible for the burst of the housing bubble. Companies like Countrywide mediate clients to banks or set up a mortgage loan by themselves. The problem arose when the banks purchased mortgage loan packages from these agencies (Luhby). Often banks were not aware of the real ability of the creditor to actually pay back the loan. In fact, Countrywide gave very risky mortgage loans, while pretending to lend only to clients with excellent credibility (Luhby). For this reason, Countrywide’s former chief executive Angelo Mozilo was officially accused of fraud (Luhby). In the case of Countrywide mortgage loan, the banks were deceived. The banks sold financial products built with mortgage loans not being able to know their real risk.

Besides selling these mortgage loan derived products, the banks’ role as an insurance isssuer also caused the Financial Crisis of 2008.  The insurance can be in the form of well known life insurance or other types securing the buyer of the policy against a particular event explains lecturer Barbara Casu. One of these kinds of insurances particularly played an important role in the financial crisis. So-called credit default swaps insure the seller of a credit derived security against the default of the actual costumer, says  Darrell Duffie, a Princeton scholar of finance. To put it more simply, if bank A’s creditors (those parties owing money to the bank) cannot pay back the loan for whatever reason, bank B, which issued Bank A a credit default swap, must pay bank A the loan. This is why, for instance, Bear Stearns lost its available money so fast. It had sold credit default swaps to other banks, it promised other bank to compensate, when mortgages loans would to be repaid.

New York Times author Justin Fox argues that the Congress was partly responsible for the credit default swaps becoming so dangerous. The Commodity Future Trading Commision supervised and regulated credit default swaps and similar financial products - until 2000. At this point, congressmen pushed through the a Future Trading Modernization act that exempted credit default swaps from regulation (Fox). One could argue that it is problematic and that the nature of profit seeking companies to accept a given risk. However, the fact that this risk taking in the form of credit default swaps trade was not supervised is the fault of the Modernization Act, and ultimately Congress.

Only financial experts will be able to fully understand these financial instruments. But even they are befuddled. “I am a trained economist and I can not understand the banking sector anymore”, said a protestor of the Occupy Frankfurt demonstration on October 14^th to the German broadcaster ARD. It is definitely a weakness of the banking sector, that the general public cannot understand what is going on. This gap in understanding creates anxiety, which definitely contributed to the the rise of the protests (Frontline).

Many critics argue that banks had become “too big to fail”.  For the following reason, the failure of one bank that is “too big to fail” would have devastating effects on the economy. Diversification of one banking group in all areas of the banking sector (commercial, corporate, investment) and financial instruments like credit default swaps created a new interconnectedness among different departments of one bank and among different banks. (Frontline) This is what made the financial market dangerous. If one department of a bank fails, the whole bank could lose its equity (disposable monetary asset of the bank) and could affect many other financial institutions that are connected to the bank. The failure of one bank puts the whole economy under stress, a Wall Street critic would argue. This became obvious from the failure of Lehman Brothers and the subsequent crash of the stock market. On the other hand, the interconnectedness also explains why it is so important that the government rescues a bank that is highly connected. Critics are right that bailing out a failing bank is very costly to the taxpayer, but according to “13 Bankers” Simon Johnson this becomes necessary in the case of a very interconnected bank (Johnson 154).

For many critics of the banking sector, the rescue of a bank poses a moral problem. The New York Times writer Joe Nocer calls it “moral hazard”: “Moral Hazard poses the question, if you bail somebody out of a problem they themselves caused, what incentive will they have to not repeat that problem again?” So, if a bank considers engaging in the trading of something that could turn out to be very profitable, the bank will accept a higher risk if it knows that a government will bail it out. The bank loses the incentive to lower the risk of trading. 

Skeptics might argue that one should break large banks into smaller ones, so that they are not too big to fail. Nobel laureate Paul Krugman argues that this would not resolve the problem, because in the 1930s it was particularly small banks that collapsed and caused tremendous damage to the economy. Banks become more efficient as they grow and large banks are worth being protected (Krugman).

It is understandable that the uninformed public can be offended when large sums of tax money are used to save a company, especially if the company is engaged in risky deals as a gamble for greater profit. The general public might be worse off if the taxpayers money is used. For instance, in September 2008, the investment bank Lehman Brothers collapsed and the Federal Reserve decided not to save it as it did with the bank Bear Stearns. Within four days of Lehman’s bankruptcy, all Lehman shares, in which for instance all 20,000 employees stored their wealth, became worthless and many other banks and insurance companies had to be rescued, according to The Independent journalist Stephen Foley from September 2008. Perhaps an even worse result was that banks were so afraid of each others’ potential failure that the banks would not lend money to one another, what also lead to less investments in the real economy (Frontline).

But what should be done to avoid this happening in the future? The protestors are right: we can not simply wait for the next meltdown to come. Author and economist Darrell Duffie explains potential solutions, which perhaps can prevent another crisis. One measure suggested was that already weak banks must have the opportunity to recapitalize, to accumulate disposable and always accessible money (43). The central bank could secure low interest credits to this bank or even offer in advance to purchase the credit default swaps (45). Additionally, the markets need to be more regulated. Regulation measures could take various forms, but popular ones would demand a financial institution not to use a long run deficit strategy. That means that a bank must have enough money in 30 years at its disposal, so it can to pay off all credits that are due within 30 years.

 

  Similarly, the government could legislate how much of a certain security type, such as mortgage loan securities, a bank can acquire or issue. (47)

Our whole economy depends on the banking system and much of the problems in the banking sector were created by interdependency of the banks. While some criticism voiced by Wall Street occupiers is justified, painting a picture that the incredibly rich banker has dragged down the economy all by himself is not fair. Instead the blame should shared among bankers, real estate agencies and policy makers alike.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Bibliography

 

Addley, Esther. "Occupy Movement: from Local Action to a Global Howl of Protest | World News | The Guardian." Latest News, Sport and Comment from the Guardian | The Guardian. 17 Oct. 2011. Web. 26 Oct. 2011. <http://www.guardian.co.uk/world/ 2011/oct/17/occupy-movement-global-protest>.

 

Dobnik, Verena. "Wall Street Protesters: We're in for the Long Haul." Bloomberg BusinessWeek. 2 Oct. 2011. Web. 14 Nov. 2011.<http:// www.businessweek.com/ap/financialnews/D9Q4CNR81.htm>.Duffie, 

 

Darrell. How Big Banks Fail and What to Do about It. Princeton, NJ: Princeton UP, 2011. Print.Foley, Stephen. "Crash! Shares Tumble as Lehman Brothers Collapses and Fears Grow for AIG - Business News, Business - The Independent." 

 

The Independent. Web. 17 Oct. 2011. <http://www.independent.co.uk/news/ business/news/crash-shares-tumble-as-lehman-brothers-collapses- and fears-                        grow-for-aig-931981.html>. 

 

Fox, Justin. "Phil Gramm Says the Banking Crisis Is (Mostly) Not His Fault - TIME." Breaking News. New York Times, 24 Jan. 2009. Web. 26 Oct. 2011. <http:// www.time.com/time/business/article/0,8599,1873833,00.html>.

 

French, Meghan. "The Banking Industry: A Vital Component of the U.S. Economy." American Bankers Association. Web. 16 Oct.2011.<http://www.aba.com/Press+Room/                 banking_background.htm>.

 

Inside the Meltdown. Frontline. 17 Feb. 2009. Web. 14 Oct. 2011.<http://www.pbs.org/ wgbh/ pages/frontline/meltdown/view/>.

 

Johnson, Simon, and James Kwak. 13 Bankers: the Wall Street Takeover and the next Financial Meltdown. New York: Pantheon, 2010. Print

 

Lessing, Lawrence. "#OccupyWallSt, Then #OccupyKSt, Then #OccupyMainSt." Huffington Post, 05 Oct. 2011. Web. 16 Oct. 2011. <http://www.huffingtonpost.com/lawrence- lessig/occupywallst-then-occupyk_b_995547.html>.

 

Tagesschau. ARD - Erster Deutscher Rundfunk. Tagesschau.de. 15 Oct. 2011. Web. 15 Oct. 2011. <http://www.tagesschau.de/multimedia/livestreams/index.html>.