It’s not just that banks are no longer
needed–they pose a needless and potentially catastrophic risk to
the nation. To understand why, we need to understand the key
characteristics of risk.
The entire banking sector is based on two
illusions:
1. Thanks to modern portfolio management, bank
debt is now riskless.
2. Technology only enhances banks’ tools to
skim profits; it does not undermine the fundamental role of banks.
The
global financial meltdown of 2008-09 definitively proved riskless
bank debt is an illusion. If
you want to understand why risk cannot eliminated, please read Benoit
Mandelbrot’s book The
(Mis)Behavior of Markets.
Technology
does not just enable high-frequency trading; it enables capital and
borrowers to bypass banks entirely. I
addressed this yesterday in Banks
Are Obsolete: The Entire Parasitic Sector Can Be Eliminated.
Unfortunately for banks, higher education,
buggy whip manufacturers, etc., monopoly and propaganda are no match
for technology. Just because a system worked in the past in
a specific set of technological constraints does not mean it
continues to be a practical solution when those technological
constraints dissolve.
The current banking system is essentially
based on two 19th century legacies. In that bygone era,
banks were a repository of accounting expertise (keeping track of
multitudes of accounts, interest, etc.) and risk
assessment/management expertise (choosing the lowest-risk borrowers).
Both of these functions are now
automated. The funny thing about technology is that those
threatened by fundamental improvements in technology attempt to
harness it to save their industry from extinction. For example,
overpriced colleges now charge thousands of dollars for nearly
costless massively open online courses (MOOCs) because they retain a
monopoly on accreditation (diplomas). Once students are accredited
directly–an advancement enabled by technology–colleges’
monopoly disappears and so does theirraison d’etre.
The same is true of banks. Now that accounting
and risk assessment are automated, and borrowers and owners of
capital can exchange funds in transparent digital marketplaces, there
is no need for banks. But according to banks, only they have the
expertise to create riskless debt.
It’s not just that banks are no longer
needed–they pose a needless and potentially catastrophic risk to
the nation. To understand why, we need to understand the key
characteristics of risk.
Moral hazard is what happens when people who
make bad decisions suffer no consequences. Once
decision-makers offload consequence onto others, they are free to
make increasingly risky bets, knowing that they will personally
suffer no losses if the bets go bad.
The current banking system is defined by
moral hazard. ”Too big to fail” also means “too big to
jail:” no matter how criminal or risky the bank managements’
decisions, the decision-makers not only suffered no consequences,
they walked away from the smouldering ruins with tens of millions of
dollars in personal wealth.
Absent any consequence, the system created
perverse incentives to pyramid risky bets and derivatives to increase
profits–a substantial share of which flowed directly into the
personal accounts of the managers.
The perfection of moral hazard in the
current banking system can be illustrated by what happened to the
last CEO of Lehman Brother, Richard Fuld: he walked away from the
wreckage with $222 million. This is not an outlier; it is
the direct result of a system based on moral hazard, too-big-to-jail
and perverse incentives to increase systemic risk for
personal gain.
And who picked up all the losses? The
American taxpayer. Privatize profits, socialize losses:
that’s the heart of moral hazard.
Concentrating the ability to leverage
stupendous systemic bets in a few hands leads to a concentration of
risk. Just before America’s financial sector imploded,
banks had pyramided $2.5 trillion in dodgy mortgages into derivatives
and exotic financial instruments with a face value of $35 trillion–14
times the underlying collateral and more than double the size of the
U.S. economy.
In a web-enabled transparent exchange of
borrowers bidding for capital, the risk is intrinsically dispersed
over millions of participants. Not only is risk dispersed,
but the consequences of bad decisions and bad bets fall solely to
those who made the decision and the bet. This is the foundation of a
sound, stable, fair financial system.
In a transparent marketplace of millions of
participants, a handful of participants will be unable to acquire
enough profit to capture the political process. The present
banking system is not just a financial threat to the nation, it is a
political threat because its outsized profits enable bankers to
capture the regulatory and governance machinery.
chart
courtesy of Market
Daily Briefing
The problem with concentrating leverage and
moral hazard is that risk is also concentrated. And when
risk is concentrated rather than dispersed, it inevitably breaks out
of the “riskless” corral. This is the foundation of my
aphorism: Central planning perfects the power of threats to
bypass the system’s defenses.
We can understand this dynamic with an
analogy to bacteria and antibiotics. By attempting to
eliminate the risk of infection by flooding the system with
antibiotics, central planning actually perfects the search for
bacteria that are immune to the antibiotics. These few bacteria will
bypass the system’s defenses and destroy the system from within.
The banking/financial sector claims to be
eliminating risk, but what it’s actually doing is perfecting the
threats that will destroy the system from within. Another
way to understand this is to look at what happened to home mortgages
in the runup to the meltdown of 2008: the “safest” part
of the financial sector ended up triggering the collapse of the
entire pyramid of risk.
Once we concentrate risk and impose perverse
incentives and moral hazard as the foundations of our
financial/banking system, then we guarantee the risk will explode out
of whatever sector is considered “safe.”
Once you eliminate the “risk” of weak
bacteria, you perfect the threat that will kill the host.
The banking sector cannot be reformed, for
its very nature is to concentrate systemic risk and moral hazard into
breeding grounds of systemic collapse. The only way to
eliminate the threat posed by banks is to eliminate the banks and
replace them with transparent exchanges where borrowers and owners of
capital openly bid for yield (interest rates) and capital.
Bankers (and their fellow financial parasites)
will claim they are essential and the nation will collapse without
them. But this is precisely opposite of reality: the very existence
of banks threatens the nation and democracy.
One last happy thought: technology cannot be
put back in the bottle. The financial/banking sector wants
to use technology to increase its middleman skim, but the technology
that is already out of the bottle will dismantle the sector as a
function of what technology enables: faster, better, cheaper, with
greater transparency, fairness and the proper distribution of risk.
There may well be a place for credit unions and
community banks in the spectrum of exchanges, but these localized,
decentralized enterprises would be unable to amass dangerous
concentrations of risk and political influence in a truly transparent
and decentralized system of exchanges.
Of related interest:
Certainty,
Complex Systems, and Unintended Consequences (February 14,
2014)
Our
Middleman-Skimming Economy (February 11, 2014)
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