Banks, the Financial Crisis, and the 3 Little Pigs


I was thinking this morning about how to explain banks and the financial crisis to my kids. And the 3 little pigs story popped into my head. Warning: This is a gross oversimplification and not meant to reflect actual banking history.

Update – Newer post: Hyperinflation 2013

In contrast to the pigs, we start with a bank as a house of bricks. People who had a substantial amount of money put their money in the bank because it was secure. The bank held the money inside the brick structure.

Bankers figured out they could make money by lending some of the depositors’ money out. So they begin lending out a fairly small percentage of it. Since they still have most of the depositors’ money on hand, the house is still basically brick.

But of course, the more money the banks lend out, the more money they make. So soon enough they start lending out more than half of depositors’ money and eventually much more than that.

The house no longer looks like it’s made of bricks. Once you lend more than half the money out it looks more like it’s made of wood. And for many, if not most, they have lent out 90% or more of the money and the house is really made of straw.

Because the banks no longer look so sturdy, people become hesitant to put their money in. Confidence now becomes very important. Indeed, banking is often described as a Confidence game:

So in order to reassure people that their money is safe in banks, government took steps to restore that confidence. We have a number of government programs for this. The FDIC insures deposits. If your bank fails, the federal government has promised it will back up the banks and you won’t lose your money.

It used to be that the insurance covered accounts of up to $100,000. When that wasn’t enough to assure people with more than $100K, the government upped the limit to $250K. This means the government is protecting very wealthy people from risk. Is that what we need government for?

At this point even the straw house is starting to look sturdy by comparison. Now throw in mortgage securitization, derivatives, investment banking, and a dozen or more other things going on in today’s banks. I have a B.A. in Mathematical Economics and studied graduate level economics at Stanford, and I don’t even pretend to understand this stuff.

Banks and the banking system have become a house of cards. At the beginning of the financial crisis, the cards were starting to look ratty and the whole house was ready to come down. People were losing confidence.

So the government stepped in with the bank bailout, and kept the house of cards – our global financial system – from collapsing.

They did not deal with the ultimate problem in any meaningful way. Our global financial system is still a house of cards. We’re not sure when, and we’re not sure how, but sooner or later this thing is going to collapse.

Government should not perpetuate this. While in the past people had limited options of what to do with their money, today there are many. You can put your money in uninsured accounts with companies like Fidelity and Vanguard. They offer a wide variety of investment options including money market funds, mutual funds, stocks, bonds and more. They even have checking, credit cards and debit cards.

We don’t have to end it in one swipe. We could gradually lower the FDIC insurance limit from the current $250K by, say, $50K/year. So in 5 years the insurance would be gone. And political leaders could make it clear there will be no more bailouts.

The wealthy will have to do something else with their money. If they want to take risks, they won’t have government subsidies to fall back on.

2 Comments

  1. Warren- I think the history of Banks and banking is skewed in this perspective. Offhand I would have thought that the banking business model was along the lines of Jimmy Stewart’s Bedford Falls Bank in the movie “Its a Wonderful Life”: Bankers essentially borrow money from depositors at interest rate “X”%, and lend it out at “X+y” % interest. The banker’s income is then “y”% of their deposits. Bankers are essentially paid to consolidate deposits into profitable loans. Banks’ source of income is the interest charged on LOANS that they make. A Bank that didn’t LEND anything (your “brick” bank, where all deposits are kept in a vault and never “used”) would not be economically viable, as depositors would not earn any interest if their money is not lent out. Having only 10% of deposits on hand is “normal” throughout banking history, and banks have consortiums with other banks and the Federal Reserve to borrow from one another if depositors want their money back on demand. A bank that lends a higher fraction of their deposits will be more profitable, able to offer higher interest rates which will attract depositors in a positive-feedback cycle. For the depositor it is a “risk-vs.-profit” decision: deposit monies at low interest to banks that do not loan out much money, vs. earn a higher interest at banks lending out more of their deposits.

  2. Chris,

    Banks create money out of thin air. You deposit $100 and they loan out $90. Whoever got paid from the new borrower deposits $90 back in the bank. Now the Bank has $190 on Deposit. But only $100 cash on hand. Out of the new $90 deposit, they make a new loan of $81 which eventually comes back to the bank. Again, the bank has $100 on hand, but now owes it’s depositors $271. Keep up this cycle with the 10% reserve requirement, and the bank can eventually loan out $900 keeping this $100 in cash.

    With this reserve requirement of 10%
    At this point, the bank has assets of $100 cash, $900 in loans. Which matches the $1000 it owes depositors. If the first two borrowers default, the bank now has first $100 and only (900 – 90 – 81) = $729 in loans (mortgages). This quickly wipes out the banks owner’s capital and it becomes insolvent.

    Lower the reserver requirements to 5% or even 1%, mortgage backed securitys and credit default swaps and this house of cards collapses much quicker. This is why the FED has bailed out big banks and corporations (including foreign banks and a bank owned by Qaddafi) to the tune of $16 Trillion.

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