http://online.wsj.com/article/SB10001424052748703699204575017462822204340.html
We can end bank panics forever by limiting the
ability of lenders to create money out of thin air.
Last week, voting 70-30, the Senate confirmed Federal Reserve
Chairman Ben Bernanke for another four year term. So now what will he
do?
Phase one of the recovery is certainly complete. Since September
2008, the Fed has bought mortgage-backed securities and Treasurys, and
increased the monetary base to $2 trillion from $850 billion. 
The flood
of dollars has bank profits booming.
Sadly, banks still have all those underwater mortgage-backed
securities and derivatives, but Mr. Bernanke is assuming they will just
earn their way out of this problem. Banks also are not lending enough to
get the job-creation engine rolling again—though sooner or later they
will, at which point inflationary pressures will build tremendously. So
every currency trader, bond buyer and man on the Street wants to know
one thing: "What's the exit strategy, Ben?" Raise interest rates, shrink
the money supply and risk cratering the economy, or keep rolling along
and risk a collapsing dollar?
My guess? Mr. Bernanke will leave the money out there but restrict
banks' ability to create more out of thin air. He'll be called crazy.
Crazy like a fox.
The Fed has a once-in-a-millennium opportunity to do away with
banking panics. Investors will rejoice, but Wall Street firms are not
going to like it one bit.
The Fed has a once-in-a-millennium opportunity to do away with
banking panics
Our banking system has changed little since the days of Elizabethan
goldsmiths writing more gold receipts (aka banknotes) than they had gold
in their vaults. This "fractional reserve banking" system has caused
every major panic in this country—I've counted at least 16 of them since
1812.
Whatever the era, the story is always the same. Banks keep small
reserves, and then invest in supposedly safe "sure things" to generate
profits beyond the interest paid to depositors.
Sure things can be real-estate loans, home equity, credit card and
commercial debt. But bankers are terrible investors. There are no sure
things.
Thus modern banking is protected by the twin pillars of the Fed and
the Federal Deposit Insurance Corporation (FDIC). The Fed, founded in
1913 out of the failure of Knickerbocker Trust when it tried to corner
the copper market, finally learned after the banking crisis of 1930 that
it is the lender of last resort. And the FDIC was established in 1933
to insure depositors against losses in case the bank is so bad at
investing that there is nothing left for the Fed to lend to.
The end of bank runs? Mostly. Panics? Hardly. And Paul Volcker's
proposal to restrict proprietary trading won't change a thing. Banks
write bad loans at the top and dump them at the bottom.
Here is some recent history. The 1988 Basel accords set minimum bank
capital at 8%, meaning banks could leverage their capital at ratio of
12.5 to 1. As long as their investments didn't fall by 8%, they stayed
solvent. In 2001, U.S. minimum capital was set at 10%, more or less, but
banks were allowed higher leverage if some of their capital was AA or
AAA rated mortgage-backed securities. The rationale was that these
instruments could never possibly drop more than 5%, let alone 10%. Oops.
Under the 2004 Basel II accords, so-called shadow banks (which don't
take deposits) with $5 billion in capital were exempt from these
regulations. So institutions such as Goldman Sachs, Morgan Stanley,
Merrill Lynch, Lehman Brothers and Bear Stearns regularly used 20 to 1
or even 30 to 1 leverage. This allowed these firms to effectively print
money, inflate the housing bubble, and then watch those same AA and AAA
mortgage securities fall by 70%-90% in value.
To sum up, the Fed creates a monetary base and the banks can create
$10 for every $1 of monetary base. Wall Street firms created $20 for
every Fed $1. In other words, the Fed only seeds the market. Beyond
crude instruments like interest-rate policy, it has little control over
how much actual money supply exists. In good times banks lend too much.
And in bad times, such as today, they don't create enough money because
they lend too little.
Perhaps the lesson Mr. Bernanke drew from 2008-09 is not that we need
more regulation but that financial firms should not be allowed to
generate money out of thin air to write soon-to-be-bad loans. To seal
his legacy, it is fractional reserve banking that he can rein in. Limit
leverage and you take away the hot air from these bubbles.
Free marketers blanch at the idea of more regulation. But banking
isn't a normal market. Banks create money when it did not previously
exist. We've built a regulatory structure around this sleight-of-hand
and each time are astonished that banks still fail. I doubt we will ever
get to no leverage, a dollar loan backed by a dollar of capital, but I
think Mr. Bernanke could be headed in that direction. One potential
target is a 5 to 1 leverage limit—he could increase reserve requirements
by 1% per year until it hits 20% by 2020. With credit dear, perhaps
banks will do a better job of deciding what is a "sure thing."
You do need lending for an economy to function, but you don't need
all that much leverage. Increased reserves may be the best financial
reform we can hope for without politicians mucking it up. No need for
pay czars and repressive rules.
Even a whiff of lower leverage and increased reserves will create a
dollar rally, as inflationary fears—that banks will create too much
money when the economy gets going again—subside. Oil at $50? Gold at
$700?
If I'm right, banks and Wall Street are going to scream bloody murder
at their new shackles. But so what, they've had plenty of time to
recapitalize themselves and show record profits and compensation, a gift
of Mr. Bernanke's zero-interest-rate policy.
Tighter control of money supply would mean the Fed no longer has to
guess if banks are creating too much or too little. Lower leverage would
keep bubbles from forming in the first place. Crazy.
