“Capitalism should reward good behaviour” – David McWilliams forgets that banks aren’t like other businesses

David McWilliams on Frontline tonight (RTE 14/12/09), in relation to the Irish banking crisis, stated something along the lines of:

“We’ve forgotten what capitalism is supposed to be about: Capitalism should reward good behaviour and punish bad behaviour”

This is initially very compelling. It appeals to our sense of justice and appeals to the ideal of the hard working man being rewarded by the market for his efforts. Reality though is far more complex. First, the markets are amoral. They don’t care how good or bad you are, your business fails or succeeds by a combination of hard work and ultimately luck.  This isn’t very appealing, the idea of the entrepreneur who after months of dedication and hard work gets put out of business by a stroke of bad luck or bad timing seems harsh and uncaring but such is the reality of a modern economy. Fairness doesn’t come into it, if it did then we wouldn’t really need the Public Sector now would we? Secondly banks aren’t like ordinary businesses, they can’t be thought of in the normal logic of the free market where viable businesses thrive and poor businesses fail. Allowing a bank to fail has many more consequences than allowing a car dealership or a chain of coffee shops to fail. When a normal business fails there is misery and loss but it’s limited to the suppliers of that business (who mightn’t be repaid in full for monies owed to them), the owners of the business (who lose whatever time and money they’ve invested in the business) and the employees who lose their jobs. It’s not nice but it isn’t systematically dangerous generally speaking.

A bank is different. A bank in simplistic terms acts as a conduit between other economic entities for the transfer and storage of money. It also lends money out to economic entities and allows (in theory) for the matching of long term debts like mortgages and business loans with short term deposits (i.e. current accounts for both businesses and individuals). If a bank fails it brings down all this and a sufficiently large bank will affect everyone in some way, i.e. I may bank at AIB but the company that pays my wage might bank with BoI so if BoI comes down I won’t get paid and the company I work for might go under, so I’m not protected by personally banking with a different bank.

A bank in extremely loose terms is an entity that takes deposits and loans them out in some way. Now there are non-bank financial entities that act as de facto banks in essence but this is a separate problem and thankfully not one Ireland has to deal with.

We can’t allow bank failure because of three reasons:

a) It’s a really bad thing if a major part of the financial infrastructure of the economy collapses. A lot of people lose money and there is chaos and if there is a deposit guarantee scheme the State has to pay out a lot of money instantly. Imagine suddenly not getting paid next week, not being able to access any of your money in accounts and your credit cards not working. It really wouldn’t be pretty. Now imagine all the businesses being in that position, not being able to lodge money, able to pay wages and so on. It’d be a lot worse than anything we’ve seen so far, a lot worse. People who can remember the banking strike can tell you what it’s like when you know your money is safe! And that was in a time when people still dealt mostly in cash or by cheque. It would be far worse if it happened now with our reliance on debit and credit cards. In short, the financial infrastructure, particularly the major clearing banks (banks with a lot of depositors who deal with a lot of normal business transactions like AIB, Bank of Ireland, PermanentTSB etc) need to be protected almost at any cost.

b) If one bank fails it can undermine confidence in other banks and start a bank run on them (all it takes is a rumour to start that “AIB will be next” to start a bank run if the public are already nervous about bank stability as was shown in the Great Depression in the 1930’s). Now the problem with any bank is this, it will never have enough money to hand to pay out all depositors if they all withdraw their money at once. Now this isn’t a problem normally because this almost never happens under normal business conditions. A bank run is where this does happen and this can bring down any bank if the bank run isn’t stopped! It doesn’t matter how sensible a bank has been, if there’s a bank run on it, it can be brought under. This is crucially important to understand. People are very predictable in some ways, if everyone else is doing it then we feel compelled to do it too and if a large enough group of people start queuing outside AIB/whatever looking for that money that queue is guaranteed to get longer especially if the online banking services they provide go down (as happened with Northern Rock!). If a bank is left fail it can only be let happen when you can be pretty damn sure it won’t start a domino effect and this is very hard to know in advance.

c) The other problem is like the second one but is concerned with long term confidence and stability. If a major Irish (clearing) bank failed it would scar a generation with the losses suffered. It would undermine the future workings of banks by reducing our ability to trust that our money will be safe and if we don’t trust that our money is safe then bank runs can suddenly start (this is why we have deposit guarantee schemes by the way, not for the sake of borrowers!). The problem is guarantee schemes are a gamble, so long as confidence in banks remains high, they don’t cost any money. As soon as a bank fails they cost a lot of money. There was a time, in the States, where some banks financed their own insurance style schemes to protect against bank runs (if one of the group suffered a bank run the other banks would band together to make sure that bank had enough cash to meet demand and by doing so hopefully avert bank runs before they even happened because if people believe that the other banks will fund the bank during a bank run they won’t bother to queue outside it for money and because of this no bank run happens etc). The issue was this, a second group of banks started in operation which didn’t pay into these schemes and because they didn’t pay into them they could offer savers a higher rate of interest on deposits and so on making them more attractive to savers while the stability exuded by the system of insurance by banks rubbed off on them a bit because the average man on the street isn’t going to be that well informed on which banks are in and which banks are out of such a scheme. In short it’s the free rider problem and so the State needs to enforce the guarantee scheme on all banks or it won’t work.

The other half of this is stability of the overall economy. Instability can mean outsiders won’t lend to our banks and people in the country might opt for shares, bonds or whatever instead of deposit accounts or more problematically invest their money abroad in order to avoid the Irish banking system/economy altogether (for a good treatment of capital flight from economies in crisis in the latter half of the 20^th century see Paul Krugman’s recently reissued book  The Return of Depression Economics). This reduces the pool of potential loanable funds. This reduces the level of investment in the economy, now this is only a problem if there is a shortage of liquidity in the system (i.e. good businesses with sound business plans can’t get loans like what’s apparently happening at the moment according to Small and Medium Firms Association and others). Stability encourages confidence in the system, confidence in the system averts the possibility of bank runs that could bring down otherwise healthy banks and further than this confidence increases the liquidity available in a country by allowing for investment inflows to occur.

So in short we can’t leave the banks’ collapse, no matter how badly the managers of these banks may have screwed up. This is infuriating on a personal level for most people, myself included, but we don’t have a choice. Arguably the Government should have gone for temporary nationalisation rather than NAMA (as has been argued by many well regarded Irish Economists) but people need to realise and to be told that what we’re debating is how best to save the banks not whether to save them and cries of “There’s money for the bankers but no money to keep public wages high” are missing the point. We’ve no choice but to bail out the banks. To let them fail would be far too dangerous and risky to contemplate. It’s galling but whoever said life was fair anyway?