Why big US banks should be allowed to fail? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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Why big US banks should be allowed to fail? 

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In this issue:
» New US immigration bill fatal for Indian IT companies
» West is treading in deflationary waters
» Why the future of Euro is bleak?
» Retail inflation rises in October
» ...and more!


00:00
 
Debt excesses of the past led to financial crisis in 2008. And while the world economy is yet to emerge from this financial shock, regulatory incompetence has meant that we are further burying our feet deep into the crisis. It is a known fact that the crisis of 2008 has its roots in the US banking system.

Predatory lending practices led to defaults as borrowers were unable to repay. This shook the entire banking system. But subsequently the large banks were bailed out as they were deemed too-big-to-fail. In other words, regulators felt that allowing these banks to fail can have cascading effects on the economy. Therefore, they were bailed out. As a result, these banks which should have been extinct have continued to thrive.

However, Senator Elizabeth Warren has taken on Obama administration for being too soft on them. She stated that such bail outs have cost nearly US$ 83 bn a year of tax payer's money raising doubts whether the government is run for such financial institutions or an average American. We cannot agree more with her. You would be surprised to know that between 2008 and now, the four largest US banks have grown in size by 30%! And the five biggest institutions hold more than half of the banking assets in US. Instead of being asked to downsize, these institutions have in fact expanded and now control the US banking industry.

This questions the regulatory competence of the world's largest economy. Institutions are being milked at the cost of tax payer's money. And this is not prudent especially when the government is running a huge deficit. Money that can be used to plug the deficit is being used in bail outs instead! While the government feels that allowing such banks to fail may lead to large scale unemployment, we feel that allowing them to survive can present even greater dangers to the economy.

Allowing them to function the way they do can create havoc in the banking system. External government support will encourage them to take even greater risks as they know they will be bailed out. They know they have a life line support from tax payer's money. It gives them a demigod status. And this is dangerous for the US financial system.

We feel there should be a definite time line to end the too-big-to-fail status of such banks. This will ensure that 2008 crisis remains a history. Implementing some key provisions of the Dodd-Frank law that was passed 3 years back or reinstating Glass Steagall act which does not allow banks to engage in risky financial activities will tighten the lid on such banks.

However, it is highly unlikely that the regulators are going to take such a tough stance against any banking behemoth. Large scale lobbying and vested interests of powerful bureaucrats means that the regulator will remain a toothless tiger forever.

Do you think that the big banks in US should be allowed to fail? Let us know your comments or post them on our Facebook page / Google+ page

01:45  Chart of the day
 
Rising disposable income leads to increase in non-discretionary spend. And an increase in such spending is a sign that a nation or a state is progressing and standard of living has bettered. Recently, CRISIL carried out a study on prosperity levels of Indian states. It created a prosperity index for the same. More prosperous the state, higher the rank and vice versa. Census data of 2011 has been used for this study. While constructing the index ownership pattern of consumer durables is taken into consideration. The rationale behind the same is that a prosperous state should contain higher proportion/ of households with more consumer durables than a less prosperous one. However, other critical factors like health, education and housing which are also a gauge of standard of living and thus prosperity have been ignored for this study. Thus, the rankings may not be complete in perfect sense. However, they do highlight some interesting facets.

As can be seen from the chart Punjab tops the list of most prosperous state. A vibrant agrarian economy has increased disposable income and thus has raised the standard of living of people there. Kerala comes in second due to strong tourism and farm activities. It is followed by Haryana, Karnataka and Tamil Nadu. However, the most surprising aspect is the absence of Gujarat from the top 5 list. The state comes in at sixth place in the prosperity list.

Rank on prosperity index
Source: *TN= Tamil Nadu


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02:15
 
The Indian IT industry has much to be feared if the new immigration Bill is cleared by the US. If it is cleared as it is, then immigration laws in the US will be toughened to deter outsourcing. The Bill prohibits a company from having more than 50% of its workforce on an H1B class of visa (used for locating employees on client sites). The visa fees would be hiked sharply as well. And the companies have to mandatorily publish ads for all US vacancies in US first before hiring an H1B worker.

The US legislators have been trying to come up with laws that prevent businesses from outsourcing work to countries like India. The idea is that this would help increase employment within the country. It is true that outsourcing has resulted in a loss of jobs in US. It is equally true that Indian companies have invested and created job opportunities in US. Therefore, whether the immigration rules will help reduce unemployment in US or not is debatable. But one thing is for sure. They will hurt the way the Indian IT companies do business.

02:45
 
As you would know, inflation refers to an increase in general price levels and lower purchasing power. Deflation means the exact opposite. What is better according to you? Common sense says declining prices are good. In a country where persistently high inflation has been eating into the purchasing power and savings of the masses, a deflationary trend would sound like a godsend. In fact, the traditional role of central bankers has been to keep inflation under control.

But this paradigm has transformed. The advanced countries are now grappling with very low inflation. As per an article in The Economist, the average inflation rate in the OECD nations, which comprises mainly of the developed economies, is 1.5%. Central bankers are now are trying hard to save the economies from falling into a deflationary cycle.

Why is deflation seen as a threat? While deflation decreases the general price level in the economy, it correspondingly brings down income levels as well. That wouldn't be such a problem. But deflation is a big problem when you are loaded with debt. The debt that has been borrowed is fixed at the nominal level at which it has been taken. It has to be repaid. The declining income impedes the repayment capacity. And this could eventually result in bankruptcies. Given that the developed economies are sitting on a mountain of debt, it is no wonder that they are extremely scared of deflation.

03:20
 
With US dollar's crown of being the world's reserve currency in danger of slipping away, there is a lot of debate around what would take its place. And until recently it was hoped that the Euro seemed the perfect replacement. But not anymore. Increasingly, experts are of the view that the European Union faces a serious risk of implosion. Notable amongst these is George Soros. The hedge fund titan recently commented that his worst fears about the Euro are now confirmed. As per him, instead of showing solidarity, the European Union has actually become every country by itself.

He is totally on the ball we reckon. The problem with the Union is that although it has a common currency, it does not have the ability to issue common debt. And as the New York Times points out, this has created a friction between creditor countries like Germany and debtor countries like Greece. This in turn has led to Germany doing just enough to keep these countries afloat and not taking radical measures that will pull the EU out of its misery. Thus, unless it does that, the risk of a Japan like stagnation, loom really large as per us.

04:05
 
The latest data on retail inflation is hardly comforting. For the month of October, it rose to 10.09% as compared to 9.84% in September. Once again the culprit is high food prices. Given that the Reserve Bank of India (RBI) has been quite clear that inflation takes priority over growth, rate cuts in the near future may not be on the cards. The bigger issue is to bring this inflation number down. So far the central bank has been at its wits end. High retail inflation is a problem that India has been dealing with for quite some time now. And the RBI's successive rate hikes in the recent past have not helped much in bringing this number under control. This has largely been because the government has not done its bit to tackle the issue. Poor storage facilities, supply side bottlenecks have been some of the reasons why inflation has stayed high even when monsoons have been good. Whether this scenario will be repeated this year remains to be seen. The monsoons this year have been healthy. Now only time will tell the extent of the impact it will have in bringing consumer prices down.

04:30
 
In the meanwhile Indian stock markets have shed their gains and are trading weak. At the time of writing, the benchmark BSE Sensex was down by 58 points (0.28%). Auto and PSU stocks were trading strong while FMCG and Realty stocks were trading weak. Most of the Asian stock markets were trading lower led by China and Hong Kong. The European markets opened on a negative note.

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7 Responses to "Why big US banks should be allowed to fail?"

G.P.SANGAL

Nov 14, 2013

It will fair and just to let them fail. It is necessary for Financial Institutions to learn right lessons. They will per force follow sound practices otherwise they may continue to be care less in handling nation's money. This is essential to ensure healthy practices leading to national well being.

Like 

swapan

Nov 13, 2013

I cannot resort to allow failure of large banks. But suggest more rigid control on their performance from time to time by peer group.Such a step was taken by Obama administration by withholding the ruthless steps when a few of such banks declared next year hefty performance bonus to the highly placed executives shamelessly.

Like 

Sivasankaran P Nair

Nov 13, 2013

Should not fall them but such banks should change their style of lending and recovery from defaulters is a must before giving fresh loans to old and inviting new to sunkfunds. With sound management one can manage like managing an elephant with a small spear.

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Borkar M.R.

Nov 13, 2013

1Too-big-to-fall It was talked that time in US because of certain connections or not having it, they were thrust upon the nation(poor people to suffer its effects. What the Senator has said is entirely true.
(2) This survey and the conclusions are dubious. Say in Pune around 1950/60, each house use to have 2 to 4 bicycles. The HO Family using one to go 4 work, college going children 2. No the 2 wheelers have taken the place, and probably on the loan taken from the banks. The family is owning 3 vehicles. Is it the sign of prosperity? The worst public transport is the cause and that is ultimately leading to inflation.
(3) The Govts and vested parties always bark at wrong tree.Like in India the politicians always go for for something, like Mayavati, Sena, Namoma for huge Statues. Are these things improving the lot of people? Go for root cause. Let them improve their education system and the mind state of living on the borrowed money. Things will change definitely in the next generation. Their economy will improve. The sane people there are advising "to throw away the credit card".(4) The difference between their and ours mounting debt is that theirs is "internal" "ours external". Both are dangerous. Our states and Euro stattes are on same level- state wise debt and income. Ranking on revenue vs debt. This is worth doing .
(5) Are u on the line Shri Subbaa Rao? FM, it appears has closed his line to your end. Does it explains need 4 RBI Guv 2 have Special Press Conf. this afternoon?

Like 

nalin patel

Nov 13, 2013

it is better to face truth now than later, when it will be too late. fail now then later.

Like 

H K Prakash

Nov 13, 2013

Around 1911, Rockefeller owned the GIGANTIC Standard Oil Company which controlled 90% of the oil industry in the US and nearby. Std Oil was broken into THIRTY FOUR pieces like Amoco, Chevron, Exxon, Mobil, etc. The oil industry never again reached the position of monopoly it held in 1900
(1) Have a program in place to break up the 3? /4? /5? biggest banks into 2 pieces each. (2) Again banks will merge/amalgamate/ break up. (3) No problem. Keep repeating Step 1 every 3? 5? years!!!

Like 

Abhay Dixit

Nov 13, 2013

Looks like US govt has taken a leaf out of Indian Govt policy framework. Indians bank (PSUs)too being funded by Indian govt over decades to ramp up capital. AI and many other PSUs are also kept alive for wrong reasons.

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