Why Your FDIC-Backed Bank Could
With big bank bailouts dominating the news,
there’s no better time to get the truth about bank safety.
This informative article has been excerpted
from Bob Prechter’s New York Times bestseller Conquer the Crash. Unlike
recent news articles that are responding to the banking crisis, it was published
in 2002 before anyone was even talking about bank safety. However, you may find
the information even more valuable today than ever before.
For even more information on bank safety,
visit Elliott Wave International to download the free 10-page report,
Discover the Top 100 Safest U.S. Banks. It contains details on how you can
protect your money from the current financial crisis, updated for 2008.
Risks in Banking
Between 1929 and 1933, 9000 banks in the
United States closed their doors. President Roosevelt shut down all
banks for a short time after his inauguration. In December 2001, the government
of Argentina froze virtually all bank deposits, barring customers from
withdrawing the money they thought they had. Sometimes such restrictions happen
naturally, when banks fail; sometimes they are imposed. Sometimes the
restrictions are temporary; sometimes they remain for a long time.
Why do banks fail? For nearly 200 years, the
courts have sanctioned an interpretation of the term “deposits” to mean not
funds that you deliver for safekeeping but a loan to your bank. Your
bank balance, then, is an IOU from the bank to you, even though there is no loan
contract and no required interest payment. Thus, legally speaking, you have a
claim on your money deposited in a bank, but practically speaking, you have a
claim only on the loans that the bank makes with your money.
If a large portion of those loans is tied up
or becomes worthless, your money claim is compromised. A bank failure simply
means that the bank has reneged on its promise to pay you back. The bottom line
is that your money is only as safe as the bank’s loans. In boom times, banks
become imprudent and lend to almost anyone. In busts, they can’t get much of
that money back due to widespread defaults. If the bank’s portfolio collapses in
value, say, like those of the Savings & Loan institutions in the U.S. in the
late 1980s and early 1990s, the bank is broke, and its depositors’ savings are
Because U.S. banks are no longer required to
hold any of their deposits in reserve, many banks keep on hand just the bare
minimum amount of cash needed for everyday transactions. Others keep a bit more.
According to the latest Fed figures, the net loan-to-deposit ratio at U.S.
commercial banks is 90 percent. This figure omits loans considered “securities”
such as corporate, municipal and mortgage-backed bonds, which from my point of
view are just as dangerous as everyday bank loans. The true loan-to-deposit
ratio, then, is 125 percent and rising. Banks are not just lent to the hilt;
they’re past it.
Some bank loans, at least in the current
benign environment, could be liquidated quickly, but in a fearful market,
liquidity even on these so-called “securities” will dry up. If just a few more
depositors than normal were to withdraw money, banks would have to sell some of
these assets, depressing prices and depleting the value of the securities
remaining in their portfolios. If enough depositors were to attempt simultaneous
withdrawals, banks would have to refuse. Banks with the lowest liquidity ratios
will be particularly susceptible to runs in a depression. They may not be
technically broke, but you still couldn’t get your money, at least until the
banks’ loans were paid off.
You would think that banks would learn to
behave differently with centuries of history to guide them, but for the most
part, they don’t. The pressure to show good earnings to stockholders and to
offer competitive interest rates to depositors induces them to make risky loans.
The Federal Reserve’s monopoly powers have allowed U.S. banks to lend
aggressively, so far without repercussion. For bankers to educate depositors
about safety would be to disturb their main source of profits. The U.S.
government’s Federal Deposit Insurance Corporation guarantees to refund
depositors’ losses up to $100,000, which seems to make safety a moot
point. Actually, this guarantee just makes things far worse, for two reasons.
First, it removes a major motivation for banks to be conservative with your
money. Depositors feel safe, so who cares what’s going on behind closed doors?
Second, did you know that most of the FDIC’s money comes from other banks? This
funding scheme makes prudent banks pay to save the imprudent ones, imparting
weak banks’ frailty to the strong ones. When the FDIC rescues weak banks by
charging healthier ones higher “premiums,” overall bank deposits are depleted,
causing the net loan-to-deposit ratio to rise.
This result, in turn, means that in times of
bank stress, it will take a progressively smaller percentage of depositors
to cause unmanageable bank runs. If banks collapse in great enough
quantity, the FDIC will be unable to rescue them all, and the more it charges
surviving banks in “premiums,” the more banks it will endanger. Thus, this form
of insurance compromises the entire system. Ultimately, the federal government
guarantees the FDIC’s deposit insurance, which sounds like a sure thing. But if
tax receipts fall, the government will be hard pressed to save a large number of
banks with its own diminishing supply of capital. The FDIC calls its sticker “a
symbol of confidence,” and that’s exactly what it is.
For more information on bank safety,
including how to choose a safe bank during the current financial crisis,
download EWI’s free 10-page report,
Discover the Top 100 Safest U.S. Banks.