The Real Cause of Bank Failures

My favorite section money and investment is a shell compared to what it was like 20 years. Still, many times there are gems to be read. In February 2013 under the section Heard On The Street was a piece written by David Reilly entitled Too Big to Fail Casts a Very Long Shadow – and it put real fear in me.

It picked up a comment made by New York Fed President William Dudley earlier this month advocating the Federal Reserve extending financial support for "the shadow banking industry". The term used is a misnomer to present the readers that there is something nefarious going on in the outskirts of the banking industry. These are private sector businesses that lend to the public outside of the traditional banking structure.

Why are the Fed even considering this? I believe it is the limit the competition to the banking industry.

Put simply, as this recent paper does:

"Shadow banks are financial entities other than regulated depository institutions (commercial banks, thrifts, and credit unions) that serve as intermediaries to channel savings into investment."

That might mean "securitization vehicles, [asset-backed commercial debt] vehicles, money market funds, investment banks, mortgage companies, and a variety of other entities." The Fed's Dudley focused his attention on the $2.6 trillion money-market mutual funds industry, and on the $1.8 trillion tri-party repo business – where banks themselves can go to raise short-term loans backed by Treasury bonds or other, higher-risk collateral.

What's important for a definition of shadow banking is that the lenders are not commercial banks. So they are "unregulated", which means to most commentators and regulators today that shadow banking is also "freaky". Dudley says the same, suggesting that "the existing state of affairs is not acceptable in financial stability terms." His proposal?

"The first option would be to take steps to curtail the extent of short-term wholesale finance in the system…Additional legislation or regulatory changes could be implemented to reduce the volume of [shadow banking]. The other path would be to expand the range of financial intermediation activity that is directly backstopped by the central bank’s lender of last resort function."

Entertaining these concepts, we see they are in truth one and the same – and in reality this concept is already a failure. The involvement of the Fed in regulating and back-stopping the banks has not been fortuitous. Guarantees giving the financial firms support in crisis do nothing but undermine the very responsibility that the management of said organizations should have. No regulations as we have seen from recent history will prevent mismanagement and over lending when these guarantees are in place.

Back to reading the Wall Street Journal, and I nearly fell off my chair when I read the following paragraph:

"As things stand, many players in shadow-banking markets are having their cake and eating it. They haven't been subject to much greater regulation, yet enjoy an implicit guarantee the Fed and government will step in should another crisis hit."

What implicit guarantee is Mr. Reilly speaking of? How do these non-regulated players happen to have this guarantee? I never heard about it, implicit or otherwise. Since when are these firms not allowed to fail? Why does any government organization need to support these private businesses?

It is the market and the threat of failure that prevents businesses from failing. The more the government and quasi-government agencies such as the Fed support businesses by giving them support of any monetary substance, it only increases the chances of failure. Organizations such as the FDIC are, by their very nature, incapable of creating a secure business environment, as the 2006-2009 mortgage and banking meltdown proved. It is only basic business practices that can ensure the success of any entity – not government meddling.

Still, the fact that such extra support is being considered in Washington (and taken for granted at the WSJ ) only exacerbates the current situation. It is quite apparent that the Fed is seeking to grow their already overreaching power. The mentality of our current authorities in monetary matters is to impose more and not less.

If this idea proceeds in any manner in the "shadow banking markets", I can only foresee a continued collapse in the value of the Dollar. Because the cost of guaranteeing yet another set of risk-takers will be shared equally by everyone holding the US currency.

© BullionVault

Read more commentaries by BullionVault