A couple of questions: 1. Granted that bank failures come in clumps. Why can't you account for that if you expect it to happen? 2. Why can't banks prevent bank runs by trading their assets to the depositors? For example, in your video about hedge funds, you talked about banks selling mortgage-backed securities to hedge funds. Why not do that with investors? 3. Why not demand higher reserve ratios during bad times?
the FDIC had three methods of action, they could close the bank, sell it to another party, or run it themselves. None of these options exactly give the bank a reason to take on more risk. Sal makes a valid point that the depositors will be comfortable with more risk if they are insured against losses but not the bank.
macroman52 U r right -- having insurance doesn't always make one negligent. But it does remove one of the top penalties for being not negligent. It is hard enough to evaluate a single business. A bank lends $ to many businesses, so the difficulty is multiplied by the number of businesses. I hope this helps.
think about this. it puts the wallstreet crisis in perspective. the banks all "hit the wall" and owed money. but without letting a few go bankrupt there would have been no way to absorb profit and continue the cycle. but another intersting point is that this cycle speeds up every time. it wont take long till we see wallstreet in the same sinkhole.. and then what do we do?
@johnnyfenger Banks do not collect interest on up to 10X the amount it pays u money on. If u deposited $100 into Bank1, it can loan out $90 of that to Borrower1. Borrower1 deposits that $90 to Bank2, which has to pay Borrower1 interest. Bank2 now lends $81 to Borrower2 who has to pay Bank2 interest. At each level, the Bank(s) has to pays and collects interest. For simplification purposes, all $ loaned out eventually gets deposited in some other bank.
The implication of this series of videos is that government should only be regulating the reinsurance industry to ensure that it can always honor all of its obligations. The banking industry would be better regulated by the private sector which can better evaluate the risk and react more rapidly and with greater freedoms. I see the fed's strategy of shooting for a stable inflation rate as the best one available. But the real risk must ultimately fall to those with present day assets.
@macroman52 It is much harder to evaluate risk on a bank, as each bank have many loans, each with different risk. The risk evaluation tends to require local knowledge (eg how valuable is a coffee shop in a town which tends to drink a lot of tea?), which is also difficult for an FDIC to have. A person is very easy to evaluate, based on his age and driving record -- which are easily obtainable.
@johnnyfenger No so. Remember the 10X the initial $100 came from $ circulating back in the system to other people ($90+81+ 72 ..... = $1000) , who then deposit their $ in the bank at the bank interest. So if the bank pays 5% on deposits, it will have to pay 5% on $1000, not $100
I wonder if Sal is of the opinion that fractional reserve banking contributes to the business cycle à la Austrian School. Of course he may not agree with the Austrian explanation of the business cycle in the first place. Perhaps he mentions this in a related video?
Hey Sal, is there really zero cost to you if your bank goes phut? Will the FIDC pay your deposit back immediately? Will there be some delay, some red tape? You have some incentive to chose a good bank, I think. By the same argument, car insurance makes everybody a worse driver? If insurance companies can evaluate risks, can't they evulate the risks of banks as well, and charge the right premium?
I don't think that the FDIC doesn't do anything to promote risk taking behavior of the bank. The perception of a bank, money market, or shadow bank (with no FDIC insurance) being too big to fail, will present what economists call a moral hazard.
@mwong000 I don't think this is relevant to my point that having insurance doesn't always make one negligent. But if you are right that financial risk cannot be evaluated I guess Standards and Poor should go out of business. maybe you are right.
