Public Banking: What sucks?

[Michael Chui]

I've been hearing a lot of noise about this concept called Public Banking for a month or two now and I'm a bit curious about it. I've been googling around for something negative about the whole deal and the best I've been able to find has been, "It's a great idea, but it isn't guaranteed to fix everything. That said, I'm all for it."

There's gotta be a larger downside. Does anyone here have any pointers to where I might be able to find criticisms?

[Brutha]

It would help if you would point to a concrete idea.

There's gotta be a larger downside. Does anyone here have any pointers to where I might be able to find criticisms?

Maybe you could look into the history of the Berliner Bank.

[Michael Chui]

Originally Posted by Brutha

It would help if you would point to a concrete idea.

Public Banking Institute - Home

Originally Posted by Brutha

Maybe you could look into the history of the Berliner Bank.

I will do that.

[SnerpGoodWord]

The obvious downside based on that website is that it pulls yet more economic activity into the public sphere. Next up: government owned gas stations, laundromats, restaurants and bowling alleys?

The other likely downside is that a de-facto or stated government policy of guaranteeing the public bank's debts acts in effect as a subsidy of the bank. Which might or might not be an issue depending on the capital structure of the bank.

[ar81]

Nationalizing banks would take the power away from private greedy bankers with thirst for risk. Power is natural to state. Privitizing the control of money is to privatize power to make it undemocratic.

[Curtis2011]

I think public banks are a decent idea as long as private banks are still allowed to compete in every area as the public bank, and the public bank must follow the same laws and regulations as private banks. This would add to competition in the marketplace and hopefully give more and better banking options to citizens.

I read somewhere awhile ago that in the US, almost every bank that is started is profitable, and less than 1 out of 1000 fail.

If this holds true for a public bank, it could raise money for the state government, while giving more options to the citizens.

Of course, if the bank fails, it will be the taxpayers who bail it out.

[garentee]

Originally Posted by Curtis2011

Of course, if the bank fails, it will be the taxpayers who bail it out.

Not that taxpayers have ever had to foot the bill for a private bank bailout...

[Curtis2011]

Originally Posted by garentee

Not that taxpayers have ever had to foot the bill for a private bank bailout...

Well yeah, but ideally in a mostly free market, the government would not do such things.

[Acting Like Godot]

Originally Posted by Michael Chui

There's gotta be a larger downside.

Here's the downside.

Private banks are out to make money. As far as loans are concerned, this means that they lend money to businesses which they think are most likely to succeed (so that the businesses can succeed in repaying them with interest). The private bank is not driven by philanthropic intentions, therefore it will not direct money where it's most needed, but to where it is most likely to make more money.

The public bank sounds like it's motivated by different considerations (including job creation). Its mission is to help small & medium sized enterprises, with loans. Therefore it will pump money even into businesses which are less likely to succeed. It will hesitate to pull the plug on borrowers in distress. Therefore in the long run, the public bank may lose more money on bad loans, than private banks.

[Bradman]

What about a bank that operates much like a mutual insurance company where the proceeds are shared by the members? Or is this basically the same thing as a credit union?

[SnerpGoodWord]

Originally Posted by Bradman

What about a bank that operates much like a mutual insurance company where the proceeds are shared by the members? Or is this basically the same thing as a credit union?

I think both structures are possible.

The difficulty with a depositor-owned bank (or bank-like entity) is that it must maintain sufficient equity so that losses are taken by the equity stake, not by the depositors. That's what Tier 1 capital ratios are about.

Therefore to have that sort of bank structure, people would have to not only make deposits but buy equity shares in the bank when they signed up (and in the correct ratio). That would confuse a lot of people, and they would not like potentially taking losses if the bank did.

Possible? Probably. Feasible - not in my opinion.

[ar81]

Originally Posted by Curtis2011

I think public banks are a decent idea as long as private banks are still allowed to compete in every area as the public bank, and the public bank must follow the same laws and regulations as private banks. This would add to competition in the marketplace and hopefully give more and better banking options to citizens.

Public banks do not produce toxic assets, because the money that is created is backed by the added value that comes from government spending. Interests would work like some sort of tax. So no bailouts are necessary. Not repaying your loan would be like not paying your taxes. But at least with taxes you pay for a bridge or a road, not a bonus for a failed banker.

[Acting Like Godot]

Originally Posted by ar81

Public banks do not produce toxic assets

Private banks don't have to produce toxic assets either. It's just that a certain number of prominent US and European banks have been doing that.

There are plenty of private banks in the world which never put a CDO together, for instance.

[Acting Like Godot]

Originally Posted by SnerpGoodWord

The difficulty with a depositor-owned bank (or bank-like entity) is that it must maintain sufficient equity so that losses are taken by the equity stake, not by the depositors. That's what Tier 1 capital ratios are about.

What does Tier 1 capital ratio have to do with the equity stake?

If a depositor-owned bank needs to maintain a certain Tier 1 capital ratio, it will simply have to do what the private banks have to do.

It has to take some part of its money (whether the money came from deposits or equity or fee income or whatever) and invest it in Tier 1 assets (eg high-grade government bonds) and hold those assets. That's all.

[SnerpGoodWord]

Originally Posted by Acting Like Godot

What does Tier 1 capital ratio have to do with the equity stake?

Everything. Tier 1 capital says that a bank's available capital must be some fraction of deposits. Capital comes from three places: deposits (and loans equal to or senior to the deposits), equity, and loans junior to the deposits. The idea is that in the event the bank takes losses, the losses go to the equity and/or junior loans, and deposits are untouched. Getting reserve capital from deposits would defeat that system.

In practice without equity a bank could not meet Tier 1 requirements.

[Acting Like Godot]

Originally Posted by SnerpGoodWord

Everything. Tier 1 capital says that a bank's available capital must be some fraction of deposits. Capital comes from three places: deposits (and loans equal to or senior to the deposits), equity, and loans junior to the deposits. The idea is that in the event the bank takes losses, the losses go to the equity and/or junior loans, and deposits are untouched. Getting reserve capital from deposits would defeat that system.

In practice without equity a bank could not meet Tier 1 requirements.

I never quite understand this.

Bank gets cash from different sources (eg shareholders; bondholders; depositors; fee income etc). Regardless of the source, it's all cash. Let's say (for simplicity), it's all USD cash, held in a nostro account.

Next, Bank lends some money out. Three months, let's say many major borrowers go bust, bank is in trouble. Meanwhile, in the subsequent quarter:

(1) bondholders expect their coupons
(2) shareholders hope for their dividends
(3) some depositors want to withdraw their deposit

So long as the bank remains solvent, I don't understand what is the meaning of this sentence:

The idea is that in the event the bank takes losses, the losses go to the equity and/or junior loans, and deposits are untouched.

What I mean is that:

(1) if a bond coupon payment falls due, and the bank has money, the bank will pay

(2) if a depositor arrives at the branch and wants to withdraw, and the bank has money, the bank will pay.

(3) if dividends have been declared, and are due on a certain date, and the bank has money, the bank will pay.

In a sense - it's a "first come, first served" basis. As long as the bank is solvent, it will pay whoever is due to be paid (and none of its creditors will "take a loss" in any particular order.

And the bank will pay using cash (which could have come from equity, bondholders, fee income, depositors - it's all indistinguishable now, mixed up in the nostro account).

If a depositor wants to withdraw on Monday, and the bondholder is to be paid on Tuesday, then the depositor gets the money first and the bondholder gets the money next. The "vice versa" scenario is true too.

When does the "first come, first served" basis come to an end? When the bank actually runs short of money. Then somebody (who didn't get paid) puts in a bankruptcy petition (or the bank itself declares bankruptcy). Only NOW - does the waterfall kick in. Whoever is still owed something by the bank will join a queue to be paid off, and who stands where in the queue is prescribed by the law.

While the order will vary from jurisdiction to jurisdiction, certain folks - such as the taxman and the employees who are owed in arrears - tend to rank high. Also ranking high (typically) are the depositors. Next it's bondholders, and equityholders come in around the bottom.

Is this what you mean?

[SnerpGoodWord]

What you're missing is that banks don't go bankrupt like individuals or incorporation do. They are held to a higher standard by banking regulators, and the Tier 1 ratio is the means of enforcing that standard.

A standard corp is allowed to continue operating in cases where total liabilities exceed assets as long as there is cash on hand to pay liabilities as they come up. Banks are not allowed to do this. They have to maintain a buffer where their assets exceed their senior liabilities by a certain amount. If that buffer becomes too small, the bank is seized by the regulators even though assets still exceed liabilities. This is why, when the FDIC seizes a bank, they then sell it to another bank for a positive price.

In order to achieve this state, the bank must have equity. If all assets were purchased as a result of deposits, each asset would be paired with a liability and there would be no buffer. The rest of the details of the Tier 1 calculation deal with how to value assets of dubious quality.

[Acting Like Godot]

I understand that banks must have equity. All companies must have equity, actually. At least $2, to set up a shell.

What I still don't understand is your statement that losses must go to equity/junior loans first, and deposits remain untouched. Outside of a full-blown bankruptcy proceeding, I don't understand how that is supposed to happen.

See - a bank fails to meet the ratio. So it gets seized by the regulators. Next, what happens? How does a loss go first to the equity/junior loans, and how does the deposit remain untouched? What does this actually mean, in practical terms?

[SnerpGoodWord]

Originally Posted by Acting Like Godot

See - a bank fails to meet the ratio. So it gets seized by the regulators. Next, what happens? How does a loss go first to the equity/junior loans, and how does the deposit remain untouched? What does this actually mean, in practical terms?

For simplicity's sake assume there are no junior loans.

Once the regulators seize the bank, they sell it to another, better capitalized bank. The price received is payed to the shareholders just like a normal sale. But since the bank took a loss, that price will be less than what the original equity stake was, and as a result the loss will be passed on to the shareholders.

[russianrocket]

Anyone that wants the government in charge of your banks, must have forgotten what got us into the banking situation in the first place.

The government wanting everyone to get a home, and telling banks to give everyone a loan. THAT was the GOVERNMENT at work.

Handouts for all, seems to always be the motto. So I say, stay the hell away from my banking. The government was not founded to run every single aspect of our lives. It has put itself in so many aspects of our lives, and ruined each one of them. There are things it's good at, and should stick to. And the rest, get the hell out, and let the free market deal with it.

The free market would not have allowed the crash to happen. Only when the government stepped in, did anything bad happen. But lets all blame the big bad banks. Banks are a business, that caters to other business. There are things that need to be changed, but putting the government in charge, is like letting the patients run the insane asylum.

[Michael Chui]

Originally Posted by russianrocket

There are things that need to be changed, but putting the government in charge, is like letting the patients run the insane asylum.

That is a fascinating analogy. I'm curious. Who exactly are the doctors in this comparison of yours?

[SnerpGoodWord]

Originally Posted by russianrocket

Anyone that wants the government in charge of your banks, must have forgotten what got us into the banking situation in the first place.

The government wanting everyone to get a home, and telling banks to give everyone a loan. THAT was the GOVERNMENT at work.

Handouts for all, seems to always be the motto. So I say, stay the hell away from my banking. The government was not founded to run every single aspect of our lives. It has put itself in so many aspects of our lives, and ruined each one of them. There are things it's good at, and should stick to. And the rest, get the hell out, and let the free market deal with it.

The free market would not have allowed the crash to happen. Only when the government stepped in, did anything bad happen. But lets all blame the big bad banks. Banks are a business, that caters to other business. There are things that need to be changed, but putting the government in charge, is like letting the patients run the insane asylum.

While I would not say that free markets are crash-free (they're not) it is true that the elements of the 2008 crash were all government inventions. Mortgage backed securities in the US originated with Ginnie Mae. The modern incarnations came in with Fannie and Freddie and the tax treatment of thrifts in the mid-80's that made it essentially a tax requirement for a thrift to bundle and stamp their mortgages. Tranches and AIG-style CDS insurance came into play because of government requirements as to the credit ratings of bonds pensions (especially public pensions) could hold.

[russianrocket]

Originally Posted by SnerpGoodWord

While I would not say that free markets are crash-free (they're not) it is true that the elements of the 2008 crash were all government inventions. Mortgage backed securities in the US originated with Ginnie Mae. The modern incarnations came in with Fannie and Freddie and the tax treatment of thrifts in the mid-80's that made it essentially a tax requirement for a thrift to bundle and stamp their mortgages. Tranches and AIG-style CDS insurance came into play because of government requirements as to the credit ratings of bonds pensions (especially public pensions) could hold.

Not crash free, but this particular crash could have been prevented if there had not been so much government intervention.

[SnerpGoodWord]

Originally Posted by russianrocket

Not crash free, but this particular crash could have been prevented if there had not been so much government intervention.

While true, the whole course of action was set in motion to prevent yet another banking crisis. In late '86 into mid '87 there was a bear bond market that threatened to sink pretty much every thrift (aka savings and loan) in the nation. The thrifts were taking deposits at 8% in order to lend it out at 7% and clearly that couldn't continue. Congress' solution was to allow thrifts to sell their existing mortgages at market rate (aka at a loss) and get a huge tax credit, after which they would be free to lend or buy new debt at market rate. What this meant was that over the course of a few years nearly every mortgage in the country was sold to an investment bank (the only buyers in sight), bundled, stamped, and re-sold as a mortgage bond.

So on the one hand, a huge crisis was averted. On the other hand, a time bomb was armed that blew up 22 years later. I don't think it's sensible to blame the government for the blowup without at least considering why the policy was implemented and what benefits it had.

Rather than talking about it as a government vs. non-government issue, I think it makes more sense to ask basic questions about the system. For example: If thrifts can't tolerate the interest rate risk of fixed rate loans, and homeowners can't tolerate the risk of variable rate loans, do
large numbers of outstanding mortgages even make sense?