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Escaping the banking system

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In May of 2009, I pointed out that regulators' requirements for higher bank equity ratios could prolong the recession. At the time, I said the effect might be to keep the economy weak into the next year. Little did I know that it would still be as weak now, over two years later, as it was then.

Yesterday, the Wall Street Journal published an article about a bank that illustrates how the requirements still cause these problematic effects. The bank is a community bank that primarily makes loans to small businesses - like dentists, restaurants, and delivery truck drivers - with the loans averaging only about $100,000, less than a typical mortgage. It has a default rate lower than the national average. A year ago, it had an equity ratio of 9.5%, comfortably above the 4% minimum required by the FDIC.

Nonetheless, the FDIC served the bank with a an order requiring an increase in the equity ratio, presumably because it considers small businesses more risky than big businesses, recent evidence from, say, GM or Chrysler notwithstanding. Over the past year, the bank has been forced to shed half of its loans and half of its deposits - some of the latter evidently in the form of early redemptions of certificates of deposit, which while legal and written into the terms of the certificates, rarely happens under normal circumstances and can be upsetting to depositors.

The bank's equity ratio is now at 17.3%, a level which makes it very difficult for a bank to make any money. And of course that means only half as as much money is available for small businesses to get the loans they need, which of course has a negative effect on economic and job growth. Given that similar effects no doubt exist throughout the banking system, I strongly suspect this is a major contributor to the economy's inability to recover from the recent recession.

In this particular case, the bank is working on giving up its banking charter, getting rid of its remaining depositors, and serving its loan clients as an unregulated entity using private investment capital. If the current regulatory environment continues, perhaps all business lending will eventually move to such unregulated entities.

It would be better, though, if the regulators would start regulating for normal conditions, rather than for the worst conditions that could theoretically happen. After all, the FDIC was created to cover the depositors in such worst case scenarios, specifically so that the deposits could be safely used for growth under normal conditions. What's happening now makes it difficult to use the deposits, and thus makes it difficult for the growth to occur.

WSJ article:
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On August 14th, 2011 03:43 am (UTC), izmirian commented:
That's very interesting. I haven't had time to read the article yet but it does seem that requiring bank equity ratios that high isn't necessary and reduces growth.

On the topic of slow growth, I heard a talk on the radio recently by Paul Gilding, whose thesis is that the world is in for many decades of growth much lower than we are used to because of depletion of resources like fisheries, oil, etc. Of course gloomy predictions about the world's inability to continue growing due to resource constraints have been made before and proven wrong but certainly having oil and commodity prices staying high or going up during a recession is consistent with his thesis.
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On August 14th, 2011 04:56 pm (UTC), treptoplax replied:
It's an interesting point, but I wonder if, recession or no, total worldwide commodity demand is actually down. I don't have the numbers - it would be interesting to see - but I bet total demand for e.g. oil is actually up.

To an Martian, rather than US, economist, the dominant story of the last decade is probably a couple hundred million Chinese moving from really poor to poor. My guess is that that swamps the loss in demand from the developed world, but I could be wrong...
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On August 15th, 2011 09:14 am (UTC), izmirian replied:
Re: recession
It's definitely true that much of the recent increase in worldwide consumption has come from developing countries like China. The fact that commodity prices have stayed high during the current recession in the US could either be due to continued rapid demand growth in developing countries or limited resource availability. I'm not sure for Paul Gilding's point it matters much. In either case the demand is outstripping the current supply even with the developed world in a recession.

Of course the increased prices may result in enough innovation that new resources will be found or the current resources will be utilized more efficiently. Paul Gilding's thesis seems to be that we are hitting the limits so quickly that it may take several decades for innovation to catch up and in the meantime world production growth will be significantly limited due to the limited resources.
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On August 16th, 2011 11:30 pm (UTC), treptoplax replied:
Re: recession
So, I actually stumbled across numbers on oil consumption earlier today, and it's basically flat for the last three years due to increasing use in the 3rd world.

I don't see any reason why today's limited resources are more limited than the limited resources of the past, though. I think its really just a... um... 2nd-order control oscillation problem. All the oil producers are keenly aware of the last oil bubble and glut, and are being, if anything, too slow to ramp up production in response to increasing demand this time.
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On August 17th, 2011 06:43 am (UTC), psychohist replied:
Re: recession
This is sort of a general response to the thread so far.

I think peak oil is real. In the 1950s Hubbert correctly predicted peak U.S. production around 1970. Estimates for world peak oil vary from 2010 to 2030, and I believe the former estimates are closer to correct. See for example:


I don't see production declining any faster than it rose, which means the decline will happen gradually over decades. Due to increasing demand from China and India, I do think real prices will gradually rise from here on out, with a lot of variation. This means a larger proportion of future economic growth will likely be devoted to energy efficiency improvements, like hybrids and telecommuting, leaving less for other things, but I think the technology lag is years, not decades, and will be driven more by the price trajectory than by fundamental research limitations. Because the effects of peak oil are felt over decades rather than years, I don't think it has a significant part in the current delayed recovery, which is on a shorter time scale.

I don't think the same thing is happening with other commodities as with oil. Prices of other commodities are being kept high by faster recovery in other parts of the world than in the U.S., along with a lot of excess cash pumped in by the federal reserve in "QE2", along with the factors such as I mention in my original post limiting the ability to use that cash for economic growth.

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