From Thomas Hoenig [7], president of the Kansas Fed from 1991 to 2011, and current vice chairman of the FDIC, who deconstructs the state of the US financial system which can be further summarized as follows: think Titanic moments before it hit the iceberg.
Recently, Attorney General Eric Holder testified before the Senate [8] that there is a reluctance to pursue legal actions against these firms for fear of destabilizing the markets. The subsidy and its effects remain entrenched and continue to distort the free market.
This form of corporate welfare allows the protected giants — those “too big to fail” — to profit when their subsidized bets pay off, while the safety net acts as a buffer when they lose, shifting much of the cost to the public. For example, the conglomerates can cover — and even double down on — their trading positions for extended periods using insured deposits or discounted loans from the Federal Reserve that come with the commercial bank charter. The subsidy often allows them to stay in the game long enough to win the bet, but it supersizes the loss if the bet should finally fall apart.
This system distorts the market and turns appropriate risk-taking into recklessness. The result is a more concentrated and powerful financial sector — and a more fragile economy. The way to return the financial services industry to the free market is by separating trading from commercial banks and by reforming the so-called shadow banking sector [9]. Government guarantees should be limited primarily to those commercial banking activities that need it to function: the payments system and the intermediation process between short-term lenders and long-term borrowers.
Non-banking financial activities such as proprietary trading, market making and derivatives should be placed outside of commercial banks and so outside of the safety net. Trading and investment companies would be free to engage in these activities; they would be subject to the forces of market discipline and have greater incentives to innovate and thrive.
None of these reforms can be effective unless the shadow banking system is also removed from the safety net by ending the subsidy for money-market funds [7] and the short-term institutional loans known as repurchase agreements or “repos.” Money-market funds should be required to represent themselves for what they are: uninsured investments, the value of which changes daily. Similarly, repo lenders that accept mortgage-related collateral should be subject to the same bankruptcy laws as other secured creditors.
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It is time to return our financial system to one in which success is no longer achieved through government protections but, rather, through innovation and competition. While trading and investment activities are vital parts of the financial services industry, there is no economic or social rationale for protecting and subsidizing them. Financial services firms are in the business of taking risks. Our country shouldn’t attempt to take the risk out of the system. But we should absolutely stop subsidizing it.
It is, indeed, time to return to such a renormalized system, but unfortunately this will never happen until the grand systemic reboot finally takes place, this time wiping out the central banks who have doubled down in going all in on preserving the failed status quo. Then, and only then, can things be back to normal. Until then, the best anyone can do, is to allow them to reach their terminal unwind as rapidly as possible.
Full article in the WaPo [10] [10], h/t jb