The banks have recently got into trouble. They got used to being able to pawn off some Treasury bills whenever they needed cash, but last month there were no lenders. So on September 17, the Federal Reserve stepped in with $53 billion.
The good news is that the banks are not bankrupt, and the government is not giving them taxpayer money. However, there is a serious problem.
It begins with bank funding. Banks borrow from depositors, and lend to businesses and consumers. Banks make a profit by charging borrowers more than they pay depositors. They increase this profit by borrowing on a short-term basis, and lending for longer durations.
Depositors may have the right to withdraw their cash at any time, while the bank lends to home buyers. If depositors withdraw their cash, the bank cannot make homeowners pay off their mortgages. The bank risks a cash shortage.
This doesn’t mean the bank is bankrupt. The bank’s problem is not insolvency, but illiquidity. It has assets such as mortgages, but it needs liquid cash.
Banks can go to other funding sources, such as the repo market. Repo stands for repurchase. In repo, the bank sells a Treasury bill with an agreement to buy it back tomorrow for a higher price. Repo is like borrowing, with the Treasury put up as collateral. You can think of the repo market like a pawn shop for banks. They hock, not their mom’s jewelry, but their Treasury bills. Repo gives them instant cash.
Repo lenders incur no risk. Treasury bills are defined as the risk free asset. So there are normally plenty of repo lenders. If one bank needs cash, then other banks have surplus cash to lend at a profit. Cash in the banking system circulates in a closed loop. It can be transferred from one bank to another, but it does not blink out of existence.
But by Tuesday, September 17, the market was not normal. There was an acute shortage of lenders. Desperate banks bid the repo rate up to 8%. The mystery is why banks with extra cash did not want to earn a profit on it.
The short answer: regulation stops them.
Banks are given special privileges. The government guarantees bank deposits. This is called moral hazard. The Fed pushes down interest rates, which pushes up asset prices. That is called monetary policy. The government both enables and forces banks to take more risk.
To compensate for giving them privileges, the government imposes regulations. This brings us to the reason why some banks needed more cash, while the other banks wouldn’t lend.
Regulators want proof that banks have enough cash to operate for at least 30 days. That is, if markets freeze in a 2008-type crisis, banks must be able to go for a month without borrowing. This is why the banks who have extra cash did not help. They are not allowed.
Before this little $53 billion ember could flare up into a trillion dollar blazing crisis, the Fed intervened. The mainstream media was quick to assure everyone that it’s just a minor issue with the “plumbing”. They are right in one sense. With the Fed acting as pawn shop of last resort, the banking system won’t collapse.
But it demonstrates the irresolvable contradiction in our monetary system.
Fed policy offers a perverse incentive to the banks. The Fed has tried, but it cannot back off its policy. So regulations are necessary to prevent the banks from taking too much risk. But now regulation is causing a funding crisis. The Fed responded, but it’s like putting a penny in the fuse box. The banks can load up the credit circuit with more risk.
Something has to give. We must move away from central banking, with its privatized gains and socialized losses. We must rediscover the merits of the gold standard (my company, Monetary Metals, is working to make investing in the gold standard profitable). The gold standard is a free market in money.
Or else, we will lurch from crisis to crisis, each more serious than the last.