Jesse's Café Américain: The Fed's View of American Banking: No Restraints for the Katzenjammer Kids

Through the mills of God grind slowly, yet they grind exceeding small;
Though with patience He stands waiting, with exactness grinds He all.
- Baron Friedrich von Logau, Sinngedichte

Mr. George Washington has a guest post over at Naked Capitalism that makes some points worth emphasizing. More Evidence That Banks Create Credit Out of Thin Air I find his work to be quite interesting, and a good companion to the work of Yves and Ed Harrison.

First, as we all know, banks do create money as credit 'out of thin air' in the current version of fractional reserve banking in the US. The Fed exercises some potential restraints on their ability to do so in the form of reserve requirements and Fed Funds target rates. One might think of the reserve requirement as a leash, and the Fed Funds as the price of exceeding the reach of the leash.

I had not been aware of the Fed's recent moves to eliminate the reserve requirement altogether. So, in keeping with the analogy, the Fed wishes to unleash the US banks to create money at will. One needs to realize that reserve requirements have already been significantly relaxed with the ruling on the use of sweeps to alter a bank's reserve profile on an overnight basis.

This is not quite as severe or outlandish as one might suspect, since there are examples in the rest of the world where reserve requirements are not used, such as in Canada and Mexico, and the voluntary system in the UK for example. The difference of course is that these countries have other traditions, customs, and laws in place. There is no comparison between the Canadian bankers for example, and the Katzenjammer Kids of Wall Street, although Canada may be heading for a fall of its own making as well. Their real estate is looking a bit frothy, and the instances of corruption on their equity exchanges I have witnessed is something to behold, and certainly a tip of some sort of iceberg that manifests elsewhere.

What is concerning about this in the particular perhaps is that the recent crisis in the US was precipitated by a solvency crisis caused in large part by excess leverage and rampant fraud, which then triggered a liquidity crisis, and a run on the banks. The similarites between this crisis and the Panic of 1907 seem more pronounced the more that is revealed. The difference of course is that Mr. J. P. Morgan and his bankers took strong steps to prevent such an event from reoccurring for their own good. How ironic that his own bank remains at the center of the problem at this turn of the cycle, but not as a remedial influence.

As we have seen with the New York mobs with the rise of Messrs. Luciano and Lansky, the syndication of abuse and manipulation of the law and the enforcement agencies is a paradigm shift that can transform even traditional small time thuggery into seriously organized crime that can overwhelm conventional safeguards and restraints.

The purpose of reserve requirements is to uphold some Capital Adequacy Ratio, meaning that a bank would have liquid assets adequate to support the normal demands of their customers. There are obviously other ways to do this, but a reserve requirement is a quite common method of controlling what is essentially a leverage and prudence issue. CAR is a bit of an anachronism when we have Frankenstein banks such as Goldman Sachs and Morgan Stanley, the Max und Moritz of American banking, that are less bank than hedge funds with little regard for depositors and traditional function of banks. The issue there is leverage and the adequacy of collateral. Is this where the Fed wishes to take American banking?

In the case of the US, the most recent crisis was precipitated by the rampant fraud in the assets held and sold by the banks in the form of collateralized debt obligations. The assets were not of a quality or a liquidity to support the bank's balance sheet.

The most recent revelations regarding Lehman Brothers in particular are quite pointed. The bank was using swaps to hide its true capital structure and leverage, and its vulnerability to a financial shock. When push came to shove, the company crumbled with losses much larger than anyone had estimated. The laxity at the New York Fed was an issue. It shows the weakness of what is essentially self-regulation of the banks by the banks, for the NY Fed is a creature of the banks. As Lehman says, "Everyone was doing it." It is just that Lehman were the ones that fell down, as the others were 'saved' at significant public cost.

By eliminating the reserve requirement the Fed is seeking to relax the constraints of its need and ability to 'save' banks when shocks occur. If there is no reserve requirement, then the Fed need only address itself to a run on the bank. As Mr. Washington states, the Fed stands ready to provide any and all capital required. They just do not wish to do it under constraints beyond their control.

What are seeing is the natural progression of a debilitation. The financial engineers keep creating problems with their tinkering, and the solution is to keep relaxing the constraints on their actions. As the comedian used to use, what we need is "MORE POWER!"

The Fed is the last place that should receive additional power over the banking system, showing itself to be a bureaucracy incapable of exercising the kind of occasionally stern judgement, the tough love, that wayward bankers require. And the mere thought of putting Consumer Protection under their purview makes one's skin crawl with fear and the gall of injustice.

They may get it, this more power, not because it is deserved, but because politicians themselves wish to have more power and money, and this is one way to obtain it.

The next time the financial system crashes, the torches and pitchforks will come out of the barns and there will be a serious reform, and some tar and feathering in congressional committees, and a few virtual lynchings. The damage to the people of the middle class will be an American tragedy. But this too shall pass.