Is Banking Unusually Prone to Risky Practices? Posner

I think the answer is “yes,” and that this becomes apparent if we understand the Darwinian character of competition, though this is not to suggest that competition invariably, or even typically, leads to corrupt behavior. 

There are many analogies between biological evolution and commercial markets, and as a result words like “competition” and “equilibrium” are important both in evolutionary biology and in economics. In an article published in 1950 the economist Armen Alchian argued that standard economic results could be predicted as products of a struggle for survival among competitors, without need to assume conscious profit maximization by any of them. But the explicit analogizing of economic behavior to Darwinian theory is far older than 1950, and in fact reached its
apogee in the decades following the publication in 1859 of The Origin of Species—in the movement that came to be known as Social Darwinism. In its extreme form Social Darwinism advocated eugenic
breeding, to improve the human race, and the elimination of poor relief and other redistributive policies, viewed as interfering with the struggle for survival and hence with the survival of the fittest. 

But the Social Darwinists had committed a big, though common, error, which is to confuse fitness with goodness. The “fitness” in Darwinian theory is adaptation to the environment, not improvement—which brings me at last to banking, and economic competition more generally. A competitive environment favors firms that adapt to that environment; and so to determine whether a market is working well from an overall social standpoint, one has to understand the environment, and the business behavior that best enables a firm to survive and thrive in it.  An analysis so motivated is a fruitful application of Darwinian theory to competitive markets.  

“Banking” traditionally meant borrowing from persons who want by investing to defer production or consumption (in other words, to save but be compensated for saving, rather than just stuffing their savings under their mattress) and lending the borrowed money to persons who want to save less and produce or consume more. Increasingly the word “banking” is defined more broadly, as virtually any form of financial intermediation, in recognition of the greater variety of investments made by
what are still called banks in our still lightly regulated financial system. But the traditional form of financial intermediation is all I need to discuss in order to make my point. 

The obvious problem for a bank is how to earn a spread—that is, how to lend at a higher interest rate than it borrows, as otherwise it will not cover its costs. The standard answer is to borrow short and lend long. Short-term interest rates are lower than long-term rates because the risk of default is lower (there is no need to predict the borrower’s long-term health) and because the borrower retains liquidity, which is valued—in the traditional demand deposit the borrower can withdraw at a
moment’s notice the money that he’s lent the bank (a deposit is a loan). Because a long-term loan is riskier and the lender surrenders liquidity, long-term interest rates are higher, so by borrowing short and lending long the bank earns the spread it needs to survive and thrive.  

The shorter the term of the bank’s borrowed money, and the longer the term at which it lends, the bigger the spread but the greater the risk of default. If the lenders to the bank decide that the bank is making risky loans, they, or some of them, may decide to withdraw their money. The more who do, the riskier the position of the other short-term lenders to the bank is, and so they will follow suit--hence bank runs. Because the bank’s lending is long term, the bank can quickly find itself with
no liquid capital and with long-term assets consisting of loans that are risky (which is what precipitated the depositors to flee the bank) and hence may be likely to default. 

One might think that, cognizant of such risks, banks would be cautious borrowers and lenders; they would not borrow so short (and thus risk a run) or make such long-term (and therefore risky) loans. But that need not be true. Maximizing spread may be very risky in the long run, but in the short run it may generate very high profits that shareholders and managers may be able to pocket and may compensate them for the risk of a future disaster, the costs of which will be borne by others. Banks that follow a more cautious strategy and therefore have lower profits may have trouble attracting and retaining talented employees and may not be able to hold on to short-term capital (the demand deposits) against the competition of more profitable banks (profitable because less risk averse) for short-term capital. 

As we know from the global financial collapse of 2008 and the ensuing global economic depression (and there are numerous historical precursors), the collapse of a banking industry can create
large external costs. For, to repeat, Darwinian evolution is toward fitness rather than goodness. A high-risk industry with frequent bankruptcies may be optimally adapted to its economic environment, but its risks may create serious danger for the economy as a whole. That is the argument for federal deposit insurance and other traditional, though now largely dismantled, regulations of bank solvency. Other high-risk industries with frequent bankruptcies, such as the airline industry, do not pose macroeconomic risk because they are small and because the firms can continue operating in bankruptcy; they do not experience runs that leave them assetless. For such industries, deregulation may be optimal. But for banking it is not. 

In recent decades some influential conservative economists, notably Alan Greenspan, the long-term chairman of the Federal Reserve, committed a variant of the Social Darwinist fallacy. They deemed
markets, including financial markets, as “self-regulating,” in the sense of achieving socially optimal results without need for traditional regulatory controls. At the urging of these economists and under pressure from the financial industry itself, some regulatory controls were rescinded and others ceased
to be vigorously administered. The underlying assumption was that markets “work.” They do work, but in much the same way that biological evolution works. Biological evolution has produced a marvelous variety of life forms, and economic evolution has produced a marvelous variety of products and services that have greatly increased human well-being. But both types of evolution produce “good” results only as by-products to the struggle for survival. Unregulated all they can achieve is fitness in the sense of adaptation to the environment. That may be good enough in most industries, but it is not good enough, for the overall health of the economy, in banking. 

Lax regulation, particularly of nonbank banks like Bear Sterns, Lehman Brothers, and Merrill Lynch, encouraged sharp banking practices. Firms in a competitive market cannot afford to be very ethical, any more than a tiger or other predator can afford to be gentle or kind. The firms will be under heavy pressure to engage in any highly profitable practice they can get away with, even if the profits that the practice promises are short term, provided those profits are great enough to dispel or at least
greatly  lessen the concern of managers and other key employees and investors with the long term. The short-term orientation will influence the business decisions of the managers and other employees (loan officers, traders, etc.) who exercise discretion; they will try to make as much money for themselves and their firms as they can, as quickly as they can, to avoid economic extinction. 

The Darwinian analogy of markets to nature is apt—and it is a warning against a certain type of economic complacency that appears to have contributed decisively to the economic doldrums in which much of the world is languishing, as well as to the frauds and other corrupt practices in banking that have surfaced. When an industry’s structure and centrality to the economy pushes it toward assuming macroeconomic risk, the need for careful regulation is acute.

Comments

[Account Deleted]

I don't think we should ,so easily, dismiss sectors that don't pose a macro risk.
Regulators should make sure the free market is functional - and that doesn't make it less free - and protect consumers.
The first part,in theory, is easy enough but the second part is more difficult.If we accept that competition should, in some way, benefit our society then can we even call this race for profits competition? And isn't it the opposite of Darwinism when the players race for maximizing profits not survival? Sure in some cases the risks taken are "life threatening" but those are exceptions (more Darwin Awards than Darwinism) and in only some sectors.If we want to force Darwinism on the issue, I guess, we could see this as corporations being large predators and the consumer the prey.Sometimes the predators get hurt but not so much by other predators.
Went a bit offtopic there,to go back, the point that has to be made today about regulations is that regulations don't have to make the market less free, just like protecting fundamental rights doesn't make us less free (sure anarchy means a lot more freedom but that's pushing it a bit too far).The political debate shouldn't be about safeguards that ensure that the market functions well but somehow many went to extremes and forgot that.

[Thomas Rekdal]

This is a superb posting, and well argued. Judge Posner is absolutely right that the Darwinian concept of "fitness" applies only to adaptability to a particular competitive environment; it implies nothing about any broader notion of utility or "goodness." Therefore, insofar as there is an analogy between Darwinian struggles in nature and Darwinian struggles in banking (and, of course, there is, since Darwinian competition applies almost everywhere), we cannot conclude anything about the health of the economy from the health of banking.

So far, so good. But then Judge Posner again falls back upon the need for more governmental regulation of the financial services industry (the competitive environment in question). With all due respect, I think this is more a slogan than a solution. Regulators are involved in their own Darwinian struggles, which also have little to do with the health of the macro economy. I would rather see more thought given to involving the personal fortunes of bankers in the success of the banks they manage. This involves a nest of legal problems on which I would not be competent to comment. But Judge Posner would be.

[Neilehat]

All of this is vaguely familiar of an old line I once heard a while a back,"We're no longer the Liars, Frauds, Cheats, Thieves and Scroundels we once were; of course we can be unregulated or deregulated - TRUST US"! Or as it operated in the old Roman Market, "Caveat Emptor". Or as old American Farmers were to observe about "Foxes in the Hen house or pigs in poke". It just goes too prove "that the more things change, the more they stay the same"...

Regulation, is there any other way?

[Juriuskamnik]

hm that's odd. Prof. Becker in one of his interviews on youtube said that banking is one of the most regulated industries. And also in his post about banking and regulation he says that one of the main problems with banking and corruption is over regulation, not lax regulation. An prof. Posner is advocating that financial sector is not regulated enough. Can you explain your disagreements ? Cause i think that we only need to check the facts- the laws in financial sector and compare the amount of laws in it with other industries. Can you explain and show us some details about real regulation in fin. sector? And explain why you two have different views on regulation? Can you also maybe in next post show how the incentives and bank behavior is changed because of those laws?

[TANSTAAFL]

Good post by Posner. His assertion that banks are subject to lax regulation is unfounded. Banks are highly regulated and have been for many years, particularly commercial banks. Regulation of investment banks is catching up (e.g., Dodd-Frank), if it hasn't already. And Posner's call for more regulation fails to account for regulatory capture, a common regulatory failure acknowledged by Becker's accompanying post.

[OleTrondheim]

I really like you Posner. Thank you for doing the right thing :)

http://arstechnica.com/tech-policy/2012/06/in-bid-for-patent-sanity-judge-throws-out-entire-applemotorola-case/

[Gordon Longhouse]

A good summary of the incentives inherent in banking and how they might bring about undesirable results.
Missing is any sence that there is in fact a public good in "maturity transformation" i.e. borrowing short and lending long, a major source of risk in banking. Many will not lend except on condition that they can obtain instant or quick access to their money.
Many will no borrow on terms that the bank may call the loan at a moment's notice. The result of the natural order of things is that some economically useful loans are not made and some capital is sterilised.
It is for this reason, among others, that governments around the world support banking by guaranteeing bank creditors (formally just depositors but that means pretty much everybody in reality) and in return regulating bank risk making maturity transformation possible if not absolutely safe.
Historically banking and bankers have been considered rather dull. Indeed they cultivated that image so as to give a picture of "soundness" to would be depositors.
It is only in the past 20 years or so that banking has come to be associated with predatory animals. Perhaps the good judge might have spent some time discussing how this change came about.

[Terry Bennett]

We welcome Judge Posner back to lucid territory; this almost makes up for the free will post. The incisive explanation of the Social Darwinist fallacy, which has taken others a whole book to expose, is a stellar example of the value we seek here.

While I agree that after all, this is the money, and we should not necessarily enact Mr. Herbert Spencer's Social Statics, I do continue to believe that something is lost when individuals are relieved of their responsibility. Depositors used to interview a potential bank and find out about the risks their money would face there. Now we 100% do not care, because the FDIC does that diligence for us and backs its work. This cavalier attitude then sets the tone for the cascade of risky behavior we recently saw from both bankers and customers.

On the upside, the FDIC enables banks to tap into a broad base of capital from small, cautious investors who might not trust a bank without this insurance, and enables those cautious customers to avail themselves of modern banking services. Perhaps if the FDIC insured 90% or 95% up to its cap, reestablishing the depositor as an actual stakeholder, this would introduce a sufficient impetus for diligence to rebuild the culture of fundamental skepticism and vigilence by all parties that also once served us well in this crucial sector, without totally scaring people away.

[Anthony]

I really like the Darwinian analysis, and I think that Posner is dead-on to note that competition selects for competitors who adapt to the particular environment. However, with respect to competition in the banking sector, there are a couple of very important aspects of that environment which Posner glosses over: non-risk-adjusted deposit insurance, and the political reality of "too big to fail". Bankers who take more risks, like any other other businessman who takes more risks, will see a greater variance in their results - more big successes and more big failures. However, deposit insurance and government bailouts cut off the fail tail of the distribution, so that banks engaging in riskier behaviors will have a higher expected ultimate return than those engaging in less-risky behavior.

Bankrutcy law has this effect generally (as does the reality that one can't lose more than one has), but the banking industry has a higher floor on losses than in other industries due to the implicit bailout guarantee, and the lack of risk-adjusted pricing for deposit insurance. Imposing some sort of risk adjustment to deposit insurance raters would impose some costs on riskier behavior, but only to the extent that the actual arrangements managed to capture the actual risks of risky activities, especially new ones where the risk is difficult to quantify. But eliminating the political baliout guarantee will be difficult to do in a credible way, without actually letting a large bank fail, and dealing with the economic mess that creates.

[Gwebb730]

The financial industry is highly regulated, which means that Judge Posner's analysis is incorrect. The federal government, since the 1970s, has bailed out creditors, which distorts the markets because creditors do not feel the pain from lending to risky borrowers. In the latest "crisis," the federal government bailed out investment banks, insurance companies, and automobile manufacturers, which further distorts markets. In the 1990s, the federal government began a policy of encouraging home ownership by setting unrealistic targets for the GSE's ownership of sub-prime lending, which created artificial demand for residential housing and financial instruments that facilitated further investment in residential housing. Political goals and incentives have no basis in reality and lead to unsustainable booms, corruption, and fraud as everyone tries to make money where there is no real consumer demand. Using private institutions to facilitate political goals is corporatism or political cronyism. The wisest policy is to end the federal government's policies of bailing out creditors and using them to facilitate political agendas.

[Ariadne Etienne]

The fact is that lack of regulation, good regulation, is what we have and this is allowing financial catastrophes to occur. If business was smart they'd realize that good regulation helps keep the economic machinery from over heating, and ultimately, from breaking down. You don't drive your car at top speed everywhere you go, and you certainly don't drive it if you're low on oil. This is what has been done to the economy to the point where it has blown up, burned out, and disintegrated. A stable economy, one that is well regulated, provides the maximum opportunity for the maximum number of businesses to operate, and in this age of interdependence it is critical that this stability be ensured to keep the economy from running off the rails. From my experience there isn't a single rational or credible rebuttal, unless you're willing to risk everything, including your life, your business, and the entire planet to make a buck. Only a sociopath would take such a risk and we all know where these people should be locked up.

[Carlpruitt]

The Darwinian analysis is appropriate but fails to account for the true environmental adaptation made by the banks. Bankers knew they would never be required to pay a price for their bad investments. The adaptation would have been entirely different if the failed investments forced them out of business. The most crooked and dishonest bankers rise to the top when the price for bad investments is removed.

[BernardKingIII]

This article makes very little sense.

Under ordinary conditions, there's no such thing as "fitness" or "goodness" in the business world. There is only profit and loss. The businesses that make a profit survive, and the businesses that lose money cannot survive.

However, government intervention in the banking industry has created a situation where profit and loss no longer determines whether an institution will survive. For example, in order for a bank to survive it needs short term deposits. Ordinarily, the depositors would demand some level of fiscal responsibility from the bank or they would take their money elsewhere. Now, however, depositors never scrutinize where they put their money because they know it will be protected by Federal deposit insurance. As a result, the banks are given free rein to act recklessly with these deposits and can take risks that they otherwise would not be able to take if the depositors were not guaranteed their money would be returned. (The same dynamic happens every time the Federal government guarantees a loan. See student loans.)

It is Federal intervention in the banking industry - not the free market - which causes the moral hazard. The solution should not be more Federal intervention. The solution should be to remove Federal government intervention altogether, and let the free market work.

[Facebook]

Judge Posner points out that banking generally requires "borrow[ing] short and lend[ing] long." but this article fails to follow through on the implications.

With few exceptions, Banks never have enough capital to survive a run no matter how prudent they are. This is precisely because of the mismatch between the liquidity of their deposits and loans. Long experience over more than a century in multiple countries show that in a bank run, prudent and careful banks fail as much as adventurous ones.

It is true that depositors are less likely to lose confidence in a bank which is run prudently. Nevertheless, it is also the prudent course of every depositor to retrieve his money immediately at the first hint of any trouble, however unfounded we know these might be. This is true even if we know perfectly that the bank is fundamentally sound, and that acting irrationally in this way jeopardizes the bank, and hence probably our own deposits. We want to be first in the queue during a bank run.

This is the Tragedy of the Commons writ large. In a game theory type analysis, banks are an unstable equilibrium. It is the recognition of this, and their vital roles as financial intermediaries, that governments everywhere in the 20th century have stepped in to provide some sort of depositor guarantee.

Given this, i.e. that no bank will survive a bank run, banks have sensibly been "cautious borrowers and lenders" only in the sense that they should choose borrowers who would be (in the long run) able to repay their loans with interest.

I agree with you that believing that markets are "self-regulating" is a fallacy. In street markets all over the world, food sellers are generally quite happy short-changing or short-weighting their customers. When there is "cheating" going on, choices cease to be commensurate, and both buyers and sellers lose out in the long run.

However, it is empirically not true that market forces drive out cheats abandoned by their enraged customers. This is partly because given the perverse incentives in such a system, everyone is cheating to different degrees but also because it is generally quite impossible to distinguish honest or reliable sellers from those who most successfully disguise their dishonesty.

This is true for banks as well. How easy is it for even sophisticated depositors to assess the financial prudence of their bank? Is it possible to weigh such risks against, for example, an increased return (interest rates)? What are the practical costs of such a suspicious approach?