The actual root of the banking difficulties...

By Al Portner,

Where did our financial system begin to go wrong?

I believe the root of the problem is the very business model that modern banks have adopted. It used to be a bank profited from the interest it earned.

Individuals made deposits of their savings on which they were paid interest. Credit-worthy businesses and individuals borrowed the deposited money and paid a higher interest rate than was offered to the depositors. The difference between the two rates was known as “the spread” or the bank’s profit.

The owners of the bank assumed the risk of default. They were required to put some of their own money into the bank as capital and because they did -- they were very concerned about the quality of the people to whom they lent money. The capital basis of the bank and pledged assets of the borrowers ensured that depositor’s monies were safe.

Periodically, depositors lost confidence in financial institutions for a variety of reasons and many demanded their money back simultaneously. This became known as a “bank run.” Overnight, a bank’s capital resources could be depleted.

President Franklin Roosevelt created the Federal Deposit Insurance Corporation (FDIC) to address this concern. Banks were required to pay an insurance premium to the government which then stood behind the bank deposits with its full faith and credit up to a certain limit.

To maximize profits, complex and/or exotic financial instruments were designed that spread out the risk of failure of a single business among all businesses. The theory was that this was less risky for investors. Over time, transactions became much more complex and the focus of the business model changed from retail to wholesale. Bank profitability structures began to depend more on "fees" than “the interest spread.”

No longer did banks want to hold the security interests that had been the basis of their loans. It was better sell the securities and re-loan the money. Better yet, fees collected were immediate and flowed directly to the profit line. The ability of borrowers to repay now mattered less.

If a prospective homeowner didn’t qualify under traditional standards, the bank could change the standards; stretch out the term of the note; or create an exotic payback scheme. The bank became mortgage originators who passed off risk to someone else and collected his or her fees up front. Home prices inevitably rose and it was in the interest of the originator to allow it.

Fast forward to today. Combining contingent liabilities to reduce risk works if standards for determining the risk remain sound. In other words, it is necessary a lender live with the results of his or her lending and make a good portion of profits from “the spread” if the system is going to work.

Financial instruments designed to reduce risk are only as good as the underlying assets. The sum of the total reflects only itself. To prove the truth of this axiom, just take a look at your investment account.

Your thoughts on this and any other previous postings are always welcome.

Al Portner is a former daily newspaper editor and publisher who operated newspapers in seven states from Maryland on the east to Hawaii on the west. He is currently the proprietor of The Assignment Desk, LLC, an editorial services consortium with over 200 affiliate writers, photographers, and designers.

Portner is also the author of hundreds of articles and the forthcoming non-fiction book “Mark Twain and the Tale of Grant’s Memoir.” He can be reached at alanportner@theassignmentdesk.net. The Assignment Desk URL address is http://www.theassignmentdesk.net/.