Friday, November 24th, 2017

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How Banks Work

How do banks work? And why do they sometimes fail? Understanding the basics of banking can help us make sense of the current crisis and of President Obama’s plan to reform financial regulation.

Goldsmiths in 17th-century London developed an early version of banking. Since the goldsmiths owned secure vaults for storing the precious metals they used to make jewelry, wealthy Londoners entrusted their gold to a goldsmith for safekeeping. The goldsmith charged a small service fee and gave the customer a paper receipt for the amount of gold he’d deposited. Eventually, the receipts became “as good as gold”: merchants honored the paper receipts backed by gold in the goldsmith’s vault, so people no longer had to carry around heavy sacks of loot to exchange for the wares they needed.

The goldsmith then realized he could make even more income by lending at interest. Since he alone knew the amount of gold in his vault, he could extend credit by writing a receipt for 1,000 pounds of gold, even if he only had 750 pounds in his vault. This might seem like risky lending, but if the goldsmith had lots of depositors, it was unlikely that everyone would show up at the same time demanding all their gold.

Regular banks—known as “commercial” or “retail” banks—work much the same way: we trust that the bank will safeguard our money and give it back when we stick our ATM card in the slot. But the bank doesn’t simply store all its depositors’ cash in a stadium-sized vault. Rather, it invests our money in assets that can’t be sold at a moment’s notice without substantial loss. This means that if every depositor tried to withdraw all her money at once, the bank wouldn’t have enough cash on hand to pay everyone. There’s scant chance of this happening—so long as the customers trust that the bank is solvent. But if word spreads that a particular bank is going south, there’s a good chance of a “run on the bank,” in which throngs of depositors demand their cash.

Before the early twentieth century, banks were highly susceptible to bank runs, which could ruin even the healthiest institution. A rumor that a particular bank was failing would send a frenzied mob of depositors clamoring for their money, and the bank—forced to sell off its assets at bargain-basement prices—would go broke before it could pay off its debts. Once one bank fell, people would start to doubt other banks’ solvency, and bank runs would spread like a contagion—causing widespread bank failures, hysteria, and pandemics of stuffing money under mattresses.

From 1819 to 1933, the U.S. experienced a financial “panic” caused by a cascade of bank runs about every 20 years. The most devastating were the bank runs that swept the nation in 1930, 1931 and 1933—plunging the country into the Great Depression.

As part of Franklin D. Roosevelt’s New Deal, Congress passed laws to prevent bank runs and risky lending. The policymakers’ strategy was to impose tight restrictions on institutions that were so indispensable to the nation’s economic health that the government would have to bail them out if they failed—but to leave less important institutions largely unregulated. At the time, commercial banks seemed the most vulnerable part of the system: their failure posed the gravest threat to the economy as a whole.
The Glass-Steagall Act of 1933 erected a firm barrier between commercial banks, which took deposits, and investment banks, which did not.

The new law strictly limited the risks that commercial banks could take. These banks weren’t allowed to make high profits by lending out all their money at interest: they had to maintain sufficient capital and hold reserves of assets that could be quickly converted into cash. But if a commercial bank was short on cash, it could borrow from the central bank, the Federal Reserve or “lender of last resort.”

Glass-Steagall also established the Federal Deposit Insurance Corporation (FDIC), which currently insures deposits of up to $250,000 per depositor per commercial bank. Today, if we open a checking or savings account of up to $250,000 and our bank goes south, we don’t have to panic and withdraw all of our cash immediately. But if we invest our money in stocks and bonds, our investments are not FDIC-insured and may lose value. Investment banks have remained largely unregulated, because the architects of New Deal financial reform considered them less risky: since investment banks didn’t accept deposits, they were supposedly immune to bank runs.

Under the regulatory system established in the 1930s, the U.S. was free from Depression-like crises for nearly 70 years. But while commercial banks opened their books to regulators and conducted their transactions in broad daylight, investment banks remained largely unmonitored—comprising a “shadow banking system” that operated undercover, taking much more extreme risks and making substantially higher profits than their commercial cousins.

Gradually, over the past few decades, this shadow banking system grew to be at least as important and powerful as commercial banking. Some unregulated financial institutions became so integral to the economy that it should have been clear that their failure would threaten the system as a whole. The government should have extended regulations to cover investment banks and other institutions that behaved like banks, even if they didn’t fit the commercial-bank mold.

The assumption that investment banks were immune to bank runs turned out to be wrong. In 2008, a cascade of bank runs sacked the shadow banking system, which had grown enormous, extending its tentacles worldwide. According to Nobel Prize-winning economist Paul Krugman and Treasury Secretary Timothy Geithner, these bank runs on the shadow banking system unleashed the global financial crisis of 2008. “These runs involved frantic mouse clicks rather than frantic mobs outside locked bank doors, but they were no less devastating,” writes Krugman in The Return of Depression Economics and the Crisis of 2008. “Anything that has to be rescued during a financial crisis, because it plays an essential role in the financial mechanism, should be regulated when there isn’t a crisis so that it doesn’t take excessive risks.”
From our perspective in 2009, it’s evident that the shadow banking system has to be regulated. In the last year, Washington has pumped money into Wall Street investment firms and other major “shadow banks,” because these institutions were “too big to (let) fail.” And when the Fed refused to bail out the brokerage firm Lehman Brothers, its bankruptcy ricocheted throughout the global economy.

But this need for regulation is easier to see in hindsight. From Reagan through George W. Bush, most presidential administrations championed free markets and deregulation—and watched with scorn as Japan and European governments poured money into failing businesses because these institutions were “too big to (let) fail.” Ironically, in 2008 this same reasoning led Fed Chair Ben Bernanke and then Treasury Secretary Hank Paulson to bail out Fannie Mae, Freddie Mac, the insurance giant AIG, and finally to propose the $700 billion bailout, which the House passed and then President Bush signed into law on October 3, 2008.

This brief history of the rise and fall of the shadow banking system helps us understand President Obama’s plan to reform financial regulation. Released on June 17, 2009, this plan would grant the Federal Reserve power to police the shadow banking system. You can download the entire document from the New York Times website or read a condensed bullet-point version on The Wall Street Journal’s “Washington Wire” blog. For many economists, policymakers, and journalists, the president’s plan patches some gaping holes in regulation, but leaves much undone. But this is a topic for another essay.

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4 Responses to How Banks Work

  1. Tieasha says:

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  4. Sulemnan says:

    Very well written! condensed and stating a lot of key points!
    I would love to read more articles like these regarding the overviews about the economy..

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