Exclusion, Exploitation, and the Threat to Democracy
Mehrsa Baradaran
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How the Other Half Banks
Exclusion, Exploitation, and the Threat to Democracy
Mehrsa Baradaran
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About This Book
The United States has two separate banking systems todayâone serving the well-to-do and another exploiting everyone else. How the Other Half Banks contributes to the growing conversation on American inequality by highlighting one of its prime causes: unequal credit. Mehrsa Baradaran examines how a significant portion of the population, deserted by banks, is forced to wander through a Wild West of payday lenders and check-cashing services to cover emergency expenses and pay for necessitiesâall thanks to deregulation that began in the 1970s and continues decades later."Baradaran argues persuasively that the banking industry, fattened on public subsidies (including too-big-to-fail bailouts), owes low-income families a better deal⌠How the Other Half Banks is well researched and clearly writtenâŚThe bankers who fully understand the system are heavily invested in it. Books like this are written for the rest of us." âNancy Folbre, New York Times Book Review " How the Other Half Banks tells an important story, one in which we have allowed the profit motives of banks to trump the public interest." âLisa J. Servon, American Prospect
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[Government] support cannot go on forever, which underlines why the Social Contract for banks must be redrawn.
âSIR PAUL TUCKER, FORMER DEPUTY GOVERNOR OF THE BANK OF ENGLAND
One of the most important and oft-forgotten truths about any banking system is that it simply cannot exist without the government. Lending and borrowing have taken place for as long as recorded history. Before the nation-state, borrowing and lending were connected to religious temples, the nucleus of each society.1 But the banking system we know today, which allows for the development of modern economies by issuing bank notes, lending, and accepting deposits, started with an original transaction between a government and private bankers. The Bank of England was formed in 1694 because King William III needed a loan of 1.2 million pounds to finance a war against France. Forty London merchants joined forces to issue the loan. In return, the crown gave them a monopoly on issuing bank notesâthe genesis of state-sponsored paper money. The notes were, in fact, the kingâs promise to pay back the loan. He never paid it back and those notes and their successors have been circulating and multiplying ever since. The Bank of England and the network of banks it created became the model for the worldâs current banking systemâa model where the bank initially existed to meet the needs of the state. Italy, Spain, and France, too, created the first banks to help the monarchy fund a war. The United States came late to the game, but it, too, formed a banking system whose existence depended on the state.2
Today, every stable (and even unstable) economy in the world is rooted in a state-supported banking system. The only exception, Somalia, had no state-supported banks from 1990 to 2011. Coincidentally, it did not have a functioning state during that time. In fact, Somaliaâs first act of statehood was to create a central bank. Even Costa Rica, which has no army, and Kuwait, which has no taxes whatsoever, still have a state-supported banking system.3
The essential relationship between banks and the governments that enable them has largely been forgotten, yet it makes banks completely unlike any other corporation or commercial enterprise. Banks need government support. In turn, governments need banks. Banks often serve as an appendage to the state and carry out its economic policies. In other words, banks do not operate in markets guided by an âinvisible handâ but are the hands that move marketsâoften at the behest of the state.
Many people express discomfort with government âsubsidiesâ to the banking sector. And there are subsidies, to be sure. To name just a few, take the billions of dollars of bailouts that flowed to the largest banks and prevented market corrections and lowered their costs of doing business.4 Underpriced deposit insurance is the reason the deposit insurance fund had a $9 billion shortfall during the recent financial crisis.5 Banks also pay less money for credit, as explained by the leading banking-law textbook: âOn balance, we can conclude that banks receive a benefit not available to other firmsâa subsidy notably evident in lower borrowing costs.â6
Although these subsidies may be a cause for concern, to characterize state support of the banking system as solely a subsidy mischaracterizes the nature of the bank-government relationship. The federal government has created a structural framework without which banks could not exist. To call government involvement in banking just a âsubsidyâ would be like calling the wheels on your car a âbonus feature.â The government does not just subsidize the banking system. The government allows it to exist. In order to discuss some of the inequalities in the banking system, this obvious point bears emphasis and explanation. To fully grasp how banks operate, we must first understand their basic functions.
HOW BANKS WORK
To oversimplify a complex system, we can say that banks are financial intermediaries that allow individuals to readily exchange money for goods. They also enable individual savers to grow wealth by lending their excess money to others at interest. To borrow from Mary Poppinsâs âFidelity Fiduciary Bankâ:
When you deposit tuppence in a bank account
Soon youâll see
That it blooms into credit of a generous amount
Semiannually
And youâll achieve that sense of stature
As your influence expands
To the high financial strata
That established credit now commands7
By lending, banks actually create money and multiply the money supply in the economy through leverage. For example, when you deposit $100 into the Fidelity Fiduciary Bank, the bank may keep $10 in reserve and lend the other $90 to a business or individual. That business or individual then uses that $90 to purchase real estate, a good, or a service, and the person on the other end of that transaction deposits the $90 into another bank. That bank keeps a similar reserve of, say, $9, and lends out the remaining $81, and on and on. If your initial $100 is lent out ten times and each bank keeps 10 percent of that as reserve, your $100 has turned into almost $600. The banks have created $500 by repeatedly lending your initial investment.8
Although the Fidelity Fiduciary Bank relied just on deposits from its customers (or little boysâ pigeon-food money) to lend, modern banking is much more complex. Put simply, bank lending is not constrained by deposits or reserves. If that were the case, the economy would have halted in its tracks a century ago. Customer deposits are a major source of bank assets, but the relationship between deposits âinâ and loans âoutâ is not direct. In fact, deposits are created by bank loans. To repeat, commercial banks create money, or bank deposits, by making new loans. For example, when a bank makes a mortgage loan, it does not just give someone $100,000 in cash to go purchase a house. Instead, it creates a creditâa depositâin the borrowerâs bank account for the size of the mortgage. âAt that moment, new money is created,â explain Bank of England economists; this is âreferred to as âfountain pen money,â created at the stroke of bankersâ pens when they approve loans.â9 It works the same in the United States. âBanks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit âcreationââcreated literally out of thin air (or with the stroke of a keyboard).â10
The bank balance sheet now shows a new loan and a new deposit. The new deposit may mean that the bank needs to hold more âreservesâ at the central bank in order to meet customer deposit demands. The central bank just provides the reserve in exchange for bank assets. But â[in] no way does the aggregate quantity of reserves directly constrain the amount of bank lending or deposit creation.â11 A Standard and Poorâs economist explains: âThe loan is not created out of reserves. And the loan is not created out of deposits: Loans create deposits, not the other way around. Then the deposits need a certain amount of reserves to be held against them, and the central bank supplies them.â12 The credit coursing through economic channels is propelled by the central bank.13
Bank lending is not just a balance-sheet decision made by individual banks; it is also a policy decision made by the government. The government uses bank credit to sway economic forces. Governments use banks to pump currency into and out of the economy, which affects how much money is available to lend at any given time and influences the cost of a loan. The government lowers interest rates across the country by pumping more money into the economy and increases rates by taking money out. The credit market, therefore, is not governed by typical economic rules of pricing through supply and demand. Because the central bank controls the supply of currency, the cost of credit circulating through the economy at any given moment is largely a policy decision made by the governmentâs central bank.
Our central bank in the United States, the Federal Reserve, uses four levers to shape the economy and control monetary supply: (1) the federal fund rate, (2) the discount rate, (3) reserve requirements, and (4) âquantitative easing.â The central bank uses all of these measures, which are only possible with the help of the banking system, to influence the economy.14
The federal fund rate is the rate at which banks lend to each other, which influences the interest rate for all lending. Given the state of the economy and the Fedâs policy goals, it sets a target interest rate that it believes will be optimal. To reach this rate, the Federal Open Market Committee (FOMC) buys or sells government securities from or to banks depending on whether it wants to increase or decrease the economyâs money supply. The Federal Reserve holds government securities and so do banks. If the Federal Reserve wants to stimulate the economy, it tries to increase lending by lowering interest rates. If the Fed wants to push the gas pedal on a slow economy, it creates more money in the banking system by buying government treasuries from banks and giving them cash. The banks lend this cash to others, creating more money and more lending. If the Fed decides to rein in the economy to prevent inflation, it tries to increase interest rates and decrease lending. It takes money out of the economy by selling treasuries to banks, so they hold the government treasuries instead of all that cash.
The second lever, the discount rate, or the âdiscount window,â is used to allow banks to survive a ârun,â or a large number of depositors demanding their money all at once. This liquidity, or cheap loans, from the federal government allows banks to remain in business amid a short-term credit crunch or a panic. The third lever permitting the Fed to affect the availability of credit is the reserve requirement it imposes on banks. Banks are required to keep a certain amount of money in reserve that they do not lend out. Banks use this reserve to operate and meet the withdrawal needs of their customers, while the Federal Reserve uses this reserve to achieve its own policy goals of either expanding or contracting the money supply. Increasing the reserve requirement (forcing banks to hold on to more money) contracts the money available to lend and decreasing the reserve requirement increases it.
Finally, the Federal Reserve has recently engaged in a controversial strategy called quantitative easing (QE) to get a slow economy moving when the above measures have failed to increase lending. Quantitative easing entails the Fedâs purchase of a large quantity of securities in the open market to pump even more money into the banksâhence âquantitative easing.â Under QE, the Fed purchases U.S. Treasury notes and mortgage-backed securities using newly created electronic cash, which increases bank reserves. In theory, this provides banks with more money to lend so they will lower interest rates and make more loans. In 2008, the Federal Reserve bought over $1.25 trillion in mortgage-backed securities from banks on the theory that the banks would use this money to lend. Instead, the banks used most of the money to triple their stock prices through issuing dividends and buying back stocks.15
The relationship between the U.S. government, its central bank, and the nationâs private banks is complex and evolving. Borrowing from the Federal Reserve provides a significant source of bank assets. Some of this borrowing, especially during a crisis, is hard to measure. For example, in 2008 the Federal Reserve made trillions of dollars of overnight loans, the scale and nature of which were not disclosed for years.16 What is clear, however, is the governmentâs reliance on the banking system to advance its economic policies and the bankâs reliance on a steady supply of government lending.
It is easy to see why individuals and governments need banks, but why do banks need governments? It all comes down to trust. Put simply, government support is the only reason depositors trust banks, and without trust from depositors, banks donât exist. Banks need us to entrust them with our money long enough for them to lend it out to our neighbor to buy a house or start a business. But we would not give them our money and leave it there if we did not trust that it would still be there when we wanted it back. Trust is the currency of banksâwithout it, they cease to exist. How can banks assure us that they are keeping our money safe? Banks have accomplished this in the past by erecting grand buildings made of marble to give the impression of stability, stature, and that plenty of money is stored there. Some banks would even display bars of gold in the window for all to see and feel confident the bank had money to spare. It is no wonder the bank in Mary Poppins is called the âFidelity Fiduciary Bankâ: it ...