So many problems have happened in the past due to out of control lending by financial institutions on highly risky debt. The result of such practices often leads to economic disasters. This isn’t any sort of new revelation. Economists point to it and warn about it all the time. Yet, nothing ever really changes about the nature of lending institutions and their risky loans. If this is an ongoing problem that has existed and continues to exist with the knowledge of everyone that it is indeed a problem, then why doesn’t it ever get fixed?
The answer is that governments are not willing to part with fundamental tools that let them more directly manage economies. Namely, they have an unhealthy, stalker-like attraction to their central banks, and populaces have a sort of Stockholm syndrome going on with their governments.
One government problem nearly always begets another, and one government control nearly always begets some sort of series of problems. In this case, lending institutions take on risky loans because central banks provide them with enormous leverage. In the days banks and lending institutions first existed, they had the deposits of investors and/or account holders, and that was the money they had available for lending out. They kept whatever cash they believed would be necessary to cover withdrawals on hand.
Of course, this would sometimes lead to bank runs if people panicked and all wanted their money out at once. Government’s answer was to create a central bank to guarantee fund availability and create regulations governing acceptable loans, acceptable deposits, and requirements for cash on hand. This also created some highly convenient controls on monetary policy and governing the nations’ currencies.
So, now that we have what was intended to be a remedy for stabilizing economies and shoring up lending institutions to prevent bank failures, we also have some pretty serious negative side effects. If lending institutions really can’t fail, why would they care about the risk of loans? Because of this problem created by government, government then has to create more government to regulate loan risk.
We all know the government is not the height of efficiency, so regulations are never completely adequate to keep lending institutions from making risky loans. There is simply too much incentive. The money banks are required to keep on hand is a tiny fraction of what they can be provided by the central bank. So, the banks take all their additional Monopoly Money and don’t necessarily look for sound financial decisions so much as they look for ways to loan out every monetary unit they are provided and allowed to loan out. They can continue borrowing from the central bank as much as the central bank will allow and keep making loans on that money – not necessarily with respect to how financially sound they are, but more with respect to projecting losses against profitability on their Monopoly Money.
Why do lending institutions keep giving unsecured credit card debt to people who are maxed out? Why do college students leave school with mountains of debt that take years and years to repay and can often fail? It’s all because these are not really risks for lending institutions. These risks have been subsidized and encouraged by government. When banks are lending out their own deposits, they have to do so cautiously so that they do not fail.
When banks are subsidized by government and they cannot fail, their incentives shift to risks that often should not be taken. If they can’t fail, they don’t care if they take unnecessary risks, and we all pay for it in the end. Government covers and subsidizes the risk and sucks the cash away from its citizens. When we bankroll the government, it bankrolls more losses for us. We pay for it with more taxes, higher national debt loads, and decreased currency values.
Banks are insane, but it’s because government made them that way. We may have prevented some bank runs, but we have also in the process shored up poor lending practices and bad business practices throughout our lending institutions. Without central banks, we might have some bank failures, but in so doing, we would also eliminate some bad banks. Insurance companies have a means of insuring their businesses through common funds that are collected to take care of policyholders when an insurance company fails. They are covered by other insurance companies and not directly by government. Banks could easily do the same. The model is there. We just need to drop our collective Stockholm syndrome of our government captors, get rid of their overreach on our economies, and use the private models that are already available.
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