I recently finished reading the Sept. 30 issue of Rolling Stone, and was able to force myself to read the feeble attempt at political commentary known as “National Affairs.” The article was about credit default swaps (CDSs) in relation to the potential bankruptcy of oil giant BP. Before discussing solutions to the United States banking system, a clear definition of a CDS is necessary. A CDS is, essentially, insurance a lender can buy to protect the lender from a potential default. American banks will grant otherwise ill-advised loans because they have a financial safety blanket created by CDSs.
The issue is that, in some cases, there is no seller able to actually back the loan. Instead they bet that the loan will not default. Banks are the cause of the problem thanks to their loaning money they do not have.
Most, if not all, financial crises can be linked to the fact that banks do not have enough money on reserve to back the loans they grant. The issue presents two solutions: regulate reserves, or allow banks to fail.
The first has been addressed, but only after a credit crisis preceded the reforms. One issue is that the main regulatory agency, the Federal Deposit Insurance Corporation (FDIC), has little actual power in reforming policy.
For instance, the FDIC warned the federal government about the problems of predatory loans and easy credit. The government allowed banks to grant risky loans, and even encouraged it. Massive defaults followed, causing the housing bubble to burst. Long story short, the government listens to its regulatory agencies when it serves their interests. Easy credit makes people happy and politicians gain votes based on how happy people are with the economy. No wonder the government is so reluctant to listen to advice restricting access to credit.
If regulation is the option, then a non-governmental regulatory agency with actual power needs to exist, not a puppet organization with limited power in crafting policy. Politicians have too much interest in the credit market to make decisions based on what is best for the economy as a whole. The United States government clearly favors regulation, perhaps because government power is related to economic power in the sense that those in power typically have a great deal of control over financial agencies in relation to private individuals.
The second option is to not regulate the banking industry and allow banks to fail if they make unwise business decisions. Deregulation can have two possible results: more responsible lending practices or banking chaos. People are more financially responsible when they are spending their own money.
However, the government does not want banks to make decisions based solely on the safety of a loan. Why?
Because strict criteria for loans would limit access to money. Limited access to money curtails the opportunity for people to make large purchases or investments. Credit would not be cut off completely, but those with bad credit would have higher interest rates, much like how drivers with tickets or accidents pay higher rates for auto insurance. The government’s interventions in the economy in recent decades have been rooted in the desire to expand credit – for instance, to increase the number of homeowners in the United States. When banks realize they are at fault for any bad investments they chose to authorize, they most likely will choose to make more responsible loans in order to stay in business.
The true issue is that as long as there are safety nets for banks, they will continue to conduct business in an irresponsible manner. We cannot force banks to act responsibly when we simultaneously approve bailouts and manipulate interest rates through the Federal Reserve. What we can do is force banks to be independent and take responsibility for their actions.