CDXLV – Banking In Scootland

Or, The Ideal Finance System

Following my previous post, there were some excellent comments by David the Barbarian and NLR which both served to further diagnose what is wrong with the current financial system and gave me some interesting thoughts as to how to structure the ideal banking system.

Scootland is obviously my little Utopia where everything works perfectly and nothing goes wrong whatsoever and all consequences are anticipated.

Before we get too deep into banking specifically, lets revisit what we’ve already written about corporations and similar structures in Scootland. See this article on Things Going Wrong.

It is not a given that Scootland requires corporate structures. There is an incentive built into the social structure of Scootland that would promote Guilds and Coops. Guilds are organized by profession, and help ensure quality and consistency among members. They function kind of like professional certifications, but give opportunities for training. There is no limit on the number of guilds per industry, so it would be competition that helps control the guilds and ensure they promote quality and consistency. I am an accountant, I might be certified by the Scootland Accounting Guild, and have received my training from them. I might work for a firm which is affiliated with the Scootland Accounting Guild and has to get recertified every so often that it is performing up to code. A rival guild may try to surpass the Scootland Accounting Guild in quality or price, and have different firms associated with that guild. The guild would serve to train, certify, and share methods and resources. Guilds would compete nationally, as well, helping to provide more controls on the power of the Guilds.

Cooperatives are the other resource. Cooperatives exist to support industries locally and to facilitate the distribution of local goods. A good example is a blacksmithing Coop–it would serve to supply all the member blacksmiths with iron and tools, which perhaps are sourced from mining coops or others in the same region. If there was an Accounting Coop, it would distribute visors and calculators to member accounting firms. Cooperatives as a rule would be confined geographically, but would not be bound to support specific, competitive guilds.

Corporations then would fill the gaps not satisfied by Guilds or Coops. Corporations would receive a Charter directly from the Sovereign, and must be owned by a citizen of Scootland. That citizen is the person who is held accountable for the deeds of the Corporate Charter while it is in operation. The King will not look for employees if a report reaches his ears of misdeeds, but will look for the Charter holder. So the Charter holder has an incentive to ensure the Corporation is behaving responsibly. The Charter would outline a specific business activity, for a specific purpose, and a specific customer who needs what the Corporation seeks to provide.

All This Being Said…

All this being said, what role do Banks fill in society? To try to unplug from modern conceptions of banks, lets go back to the renaissance era. I think it was the Medici family who established something that looked like a modern bank. They created a system that allowed for your money to be accessed in different cities. If you were from Naples and wanted to visit Venice, you would make a deposit at the Medici Bank and they would give you a notarized certificate, so when you travel to Venice and visit a Medici Bank, they would honor the certificate and give you your deposit. This is the first function of a Bank–to access your money across Geography.

The second function of a bank we discussed in the previous article–it’s a low risk investment which earns some amount of income in the form of interest over time. In the renaissance era, there was probably not much of that. I think the original Medici banks were bank-rolled by the Medici families personal wealth, and perhaps they made money more from fees to participate in the bank than from the deposits themselves.

The third function of a bank is that of financier. People go to banks to get help paying for big things. The Medici family was famous for patronizing the arts, and modern banks help pay for real estate and other property or assets.

Can these functions be served by something other than a traditional bank?

The geographic function could be filled by a guild, because the guild transcends geography. A Banking Guild might allow you to make a deposit and access that deposit in any Guild ATM or bank. Perhaps a percentage fee for each deposit, so there is an incentive to put a lot in at once; and no fee to withdraw because it’s your own money so you are just paying for the service provided by the Guild.

The problem with banking as an investment is that it incentivizes the kind of risky behavior that caused problems for SVB and other banks. They need a way to earn money other than investing other peoples money. I think introducing fees helps solve that problem. Then perhaps they could pay a dividend to depositors from the profits of their fees, proportional to the deposits held. That means you could earn back your fee if you keep your deposit with the Guild for a long time.

So the final function would be financier. What if Banks got out of the financing game? Let the people do that–if you want a mortgage, go to the person who owns the property and negotiate terms. Really the only reason our current mortgage system works now is because people are moving entire sums of money. I paid $200,000 on this house, so I want to sell it sight-unseen and buy another house using the $200,000 I put on this house.

Maybe it doesn’t work like that in Scootland. When you sell a house, you negotiate terms and the buyer gives you a deposit and you get a “rent” from them until it’s paid.

I guess that’s where the bank comes in–if it’s a person then you get defacto Land Lords and all kinds of abuses. Selling it to the bank first allows there to be an intermediary.

Again–the Banking Guild could do this but not with depositors funds, it would have to be with their own separate reserve. They would function as facilitator and not the direct debt holder. This helps keep the relationship between people, as mediated through the Guild.

This is all very rough, I submit this idea for comment and critique.

AMDG

CDXLIV – Judgmental About Tucker

Or, A Grumpy Ramble About The Banks

In keeping with an unintentional theme of increasingly misanthropic screeds against television and media personalities, I have another report to share of things I saw on the gym TV that just didn’t make sense to me.

The funny thing is, my new state is a little more red than my old state of beloved memory, Virginia. So instead of CNN, and MSNBC dominating the televisions, it is a little more Fox News, a little more BBC. Not that BBC is biased the way Fox News is biased but international broadcasts present American news with a little more clarity.

So in the evening it was time for Tucker Carlson to address sweaty news junkies. I couldn’t hear anything my boy Tuck was saying but I could tell the broadcast was about the recent bank-run and the governments response. I am an accountant by trade and interested in matters financial, as long time readers will know, so I my curiosity was piqued by this whole affair. I have a sense of what is wrong with the banking industry, but what did Tucker have to say about it?

Tucker Carlson took this opportunity to decry the source of these ailments: Diversity and Inclusion standards in the financial industry. Instead of a meritocracy we’ve become a adjectiveocracy. Tucker took us back to 2008 and the bail-outs and the Diversity and Inclusion requirements imposed on the financial industry, and traces the origins of this crisis to that crisis.

Here’s the thing–Tucker Carlson might even be right. He probably has a valid point that selecting for people of different arbitrary qualities rather than people with competence and skill degrades the quality of our financial machine.

But that’s not THE problem here. That is A problem. It might even be a significant problem. But it’s not THE problem.

This is where I digress from yappin’ about Tuck and start talking about the financial industry. If you want to read more about Tuck, skip ahead. I’ll put a flag to let you know you’ve arrived.

Banking Bonanza

Here is how for-profit banks work. You deposit a sum of money into your account, along with a bunch of other people. The bank now has a big sum of money to play with. Here is the balance the Bank must strike: How much money does it need to have on hand to supply people with their regular cash needs? Let me amend that–what is the minimum cash balance required to keep on hand to keep the people supplied? There are different answers to the question. Let’s say it’s 10%.

Then what does the bank do with the 90% remaining? It HAS to invest it. It invests in loans–personal, automotive, mortgage loans that almost every bank offers. These are easy, but returns depend on the interest rate which is governed by the Fed. These returns pay salaries, pay interest to depositors, and overall grease the wheels of running a bank. When interest rates are low, everyone wants loans because they are affordable and often a better investment than savings. When interest rates are high, people start having trouble with their loans because they can no longer afford the interest rate. Some loans default, some loans settle, some (few) loans continue to be paid back reliably by belt-tightening citizens with money to spare. If a majority of the banks income is in loans, when interest rates go up the at-risk loan profile of the bank changes dramatically, and a bank can go from solvent to insolvent very quickly.

Another investment for banks is things like the stock market. The stock market is inherently volatile and offers some returns. The returns you can get from the stock market come in two forms: Selling an investment that has matured in value–i.e., you bought the stock low and you can sell it high; or, dividends from long term investments. Dividends are secure and predictable, “buy-low-sell-high” is not really predictable and relies more on horse-sense than science.

Another investment for banks is things like bonds, treasuries, currency speculation, real estate speculation, things like that. Bonds and treasuries are more stable, because they are from the government or other companies; speculation is unstable because it is by definition speculative.

Another thing that for-profit banks do that absolutely boggles my mind is that they go public. This is what I think the biggest problem is.

A for-profit bank will sell shares on the stock market, and wait for their stock to mature so they can get juicy cash from public investments. If the economy is bad, the stock market falls, and it has the opposite effect. Suddenly your equity-generating dynamo starts loosing money and going public suddenly seems like a very bad idea.

Let’s think about this for a moment. What exactly are you investing in? Look at my series on Rai Stones for an in-depth discussion of this. Equity of a company should represent the thing they have that no one else has. When you buy an ownership share of a company, you aren’t just buying a paper instrument, you are buying a part of the whole business. If you are a widget manufacturer, you make widgets. If you are an accounting firm, you sell accounting services. What do banks manufacture? What do they sell? How do banks make money?

Banks make money by investing other peoples money in variously risky financial instruments. So buying a share of stock is buying into the investment of other peoples money so that you can get a cut of the profit earned from the investment of other peoples money. A bank that has a good stock price means that it has a lot of other peoples money or it is earning a lot of income on it’s investments of other peoples money.

When interest rates go up, it becomes harder for a publicly traded bank to make money on its investments of other peoples money, and it’s stock price goes down because it can’t make money the way it used to.

That’s the model we are working with here. So what exactly happened?

Silicon Valley Bank invested in long term bonds. The way bonds work is you pay a big sum up front and earn an income over time, depending on the interest rate. The bonds are optimized for a certain interest rate, so when rates change, bonds can stop being useful as an investment. SVB was stuck with a lot of bonds and interest rates had gone up a lot, so the question SVB had was–do we hold on to the investments and hope the interest rates go back to where they were, or do we sell them as they are and eat a loss and raise capital through another way?

Put another way–do we keep the reduced income because we have sunk so much into it, or do we scrape back what cash we can and try to do better investments? SVB made a logical decision to sell the investments at a magnificent loss and announced to investors that they needed to come up with cash. This scared the investors who questioned the solvency of the bank, who sold their investments which aggravated SVB’s cash needs, and created a death spiral. Not only this, but depositors came a-knocking to withdraw their deposits–the lump sum which SVB was investing in the first place, and so could not provide. A run on the bank precipitated, where depositors wanted all their money out and the bank could not provide it.

Note what is going on here: All of these errors precede government intervention. SVB made a bad investment and had to eat dirt because the economy is a dynamic and changing environment. The bad investment panicked the stock holders because it is a publicly traded bank–error compounds error. The panic led to depositors panicking and trying to take THEIR money out–error compounds error compounds error.

All of this was wrong and broken before we even get to the point of government regulation. The governments response was bad and doesn’t help solve any of these problems. But do you see how there are plenty of problems with how things are set up before we even get to that point?

Talkin’ ‘Bout Tuck Again

Tucker Carlson missed the mark on this specific issue. Diversity and Inclusion is not even the worst thing about our grossly dilapidated financial industry. He picked that topic because it was politically expedient and would get people fired up. But it completely misses the point of what is wrong with the banking industry and with our government.

Other banks are struggling and may fail because of the structural problems with how they operate as banks, and not because regulators recently appointed are of a diverse background. The government response one might suggest even has incentivized failures so that they can maximize recoverable capital while the getting is good.

AMDG