The refusal of our Congress to mandate a One Dollar of Capital standard for banks is going to screw us all.
Specifically, we fraudulently allow banks to claim as “capital” their market capitalization in the stock market (among other things that are not convertible to actual money in immediate terms.) This in turn incents them to do things that increase the market’s perception of their value, which of course means taking on more and more leverage (and thus more and more risk.)
But when the market turns and that risk becomes realized instead of theoretical suddenly you’re in deep and very hot water, because the bank sees its stock price collapse right when it needs the capital to stay alive.
Never mind that you can’t spend market cap – it’s not money, any more than the fake OptionARM negative amortization balance increases that WaMu was using to “support” their dividend was money.
Do remember that WaMu blew up, incidentally.
Of course forcing banks to only lend against actual asset valuation (not “mark to fantasy”) or faux “capital” (in the form of stock price) means you can’t have all sorts of leverage out in the economy. You have to borrow actual capital from someone (or sell them capital in the form of stock) and use that to make loans, instead of simply inventing fake capital, and if the market value of the assets you lend against declines you must either dispose of the assets or raise more capital to buttress your underwater positions. This in turn means you need production in order to obtain that capital, since excess income from production that is how capital comes into being.
This limits profit to that which you actually earn, but at the same time it completely eliminates systemic risk. An individual bank can go bust but since every dollar of capital it lent (and thus can lose) is an actual dollar of someone’s capital (and not a paper-chase fraud) the damage is limited to the institution that fails and its investors.
So why don’t we do it?
Simply put our government is a Parliament of whores (with credit to PJ O’Rourke,) They’re bought and paid for, and believe that cheap credit, that is, leverage (or debt if you prefer) is the answer to all things economic.
But now with the markets collapsing (again) for the second time in less than three years there damn well ought to be some real panic in the halls of Washington DC, Treasury and The Fed.
See, there’s no ability to bail the banks out again. And if Europe’s banks blow up, and the market says they’re going to, exactly what does the government think it is going to be able to do about it?
Oh yeah, and then there’s the other problem – the yield curve is being smashed into dust. That will make profits impossible at the banks as well – borrow short and lend long only works so long as there’s a yield difference to exploit. That’s disappearing – fast.
The insanity must end while we can still do something constructive, before the market forces resolution in ways we will find very unpleasant.