Weekend Economists Escape to Cuba March 15-17, 2013

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27. Why We Should Rip the Banks in Two

http://www.bloomberg.com/news/2013-03-15/why-we-should-rip-the-banks-in-two.html

What banks do -- sell short-term debt (like deposits) to fund long-term loans -- is inherently risky. In theory, shareholders bear this risk. In practice, much of it is dumped on citizens, even though they've no claim on the returns associated with the risk-taking.

The problem is that banks have too little capital to absorb losses without going bust. Even the new, stronger Basel III rules mandate a bare minimum ratio of bank equity to bank assets of just 3 percent. This means that a bank that loses more than 3 percent of its portfolio becomes insolvent.

Aside from this sliver of equity, banks fund themselves by issuing what some scholars call "money-like" debts. In addition to government-guaranteed deposits, these include commercial paper sold to money-market mutual funds, cash-management accounts offered to pension funds and corporations, and "repo" (the sale of a security with the promise to repurchase it later).

Rightly or wrongly, owners of these bank obligations generally treat them as if they were riskless. Deposits are insured up to a limit but the other liabilities aren’t. Savers who come to doubt that they’ll get back 100 cents on the dollar generally try to convert their money-like debts into something that has absolutely no risk of default, like a T-bill. (Inflation is a risk for T-bills, but the bank obligations are no better protected in that respect.)