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Gilbert: Let Banks Fail

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Tags Money and BanksMoney and Banking

09/18/2007

In an opinion piece on Bloomberg, Mark Gilbert writes

  • The correct number of banks to fail when a credit bubble bursts is not zero. If the best way to avoid the mispricing of risk in future is to sacrifice some of the less-prudent lenders on the altar of liquidity, then let the culling commence. That is especially the case if it erases the perception that central banks will always act as lenders of last resort, even to institutions that don't deserve to survive.

This is the only piece that I can remember seeing outside of Austrian circles identifying central bank bailouts of commercial banks as a moral hazard promoting excessive risk-taking and advocating that banks be allowed to fail. Gilbert discusses remarks by UK central banker Mervyn King, who stated,

  • ``The provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behavior,'' .[and] ``That encourages excessive risk-taking, and sows the seeds of a future financial crisis.'' [and] helping commercial banks salvage their ``risky or reckless lending'' is especially dangerous because it ``encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank.''

Gilbert describes the problem as follows:

  • Banking is essentially a confidence trick. Depositors have to be confident they can draw freely from their accounts. Retailers have to be confident swiping a rectangle of plastic in exchange for goods and services will produce a balance transfer in their favor. And the banks themselves have to be confident they and their peers have sufficient assets to meet their liabilities. For now, that confidence has evaporated as hedge funds and structured investment vehicles and conduits -- spawned while the credit-market party was hopping -- come knocking at the door for handouts because the music has stopped. And thus, the banking community wants the central banks to soothe its hangover and refill the punchbowl by cutting official interest rates.

Gilbert comes closer than any mainstream financial writer that I have seen in identifying the true cause of the problem, but stops just short. As an Austrian I see the problem in the conflation of deposit banking and credit banking, which has created hybrid (or better "low-brid") financial institutions known as fractional reserve banks that can lend out customer deposits while at the same time promising that they are to be available on demand. Fractional reserve banks are always subject to bankruptcy, not because a mismatch in the time structure of assets and liabilities, but because of (as de Soto explains in his book) the contradictory nature of their legal contract with depositors. Fractional reserve banks are inherently "a house of cards".

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