Economics: I guess banking isn't quite like other businesses

Everyone has an opinion about the banking crisis. So this pseudo-pundit in pajamas blogger should feel free to opine too!

I am not a fan of bailouts but in the case of the banks, I think there really wasn't any choice.

The reason people don't want to bail out the banks is that the high level executives got rich running the banks into the ground and they seem to be "getting away with it" and the people are angry.

The economic reason why bailouts as a rule are not good is "moral hazard." The idea is that if people don't bear the full responsibility for their actions then they take more risks, often too much risk.

The fact that banks have FDIC insurance means that the banks and the customers are partially shielded from the full weight of responsibility for poor decisions. But a full free market banking system with no FDIC insurance might be even more risky because a bank is like a power utility: too many people get hurt if the system fails.

I can buy a toaster by Company X. If that toaster breaks in 8 months, I know not to buy any more toasters from Company X. I'll probably not buy a blender or a microwave from them either. If lots of people have the same experience as me, Company X will go out of business. All I've lost is the dollars I paid for the toaster.

But what happens if Bank Y messes up?

Well, in this case, with FDIC, our deposits are protected. So WaMu becomes Chase and that is about it.

But did we "lose" any money in the transaction?

If only a few banks fail, the FDIC covers.

But what if a lot of banks fail?

I suspect that one reason why the US Government had to bailout the banks is that the FDIC insurance fund couldn't have covered all the deposits of all the dead banks.

Thus, we do lose money when too many banks fail because the bank bailout money comes from the taxpayers.

But what is the alternative?

A banking system with no FDIC?

The average customer looking at Bank A and Bank B would not be able to tell which one is in poor financial health. It is one thing to lose some money buying a lousy toaster its another thing to lose a portion of your life's savings when a bank goes under.

Thus, banks need regulation.

How about these possible changes?

(1) Bigger FDIC fund.

(2) Higher capital requirements for banks.

(3) Separate out retail banking where accounts are insured (lower risk and lower reward) from investment banking where accounts aren't insured (higher risk but higher reward).

(4) Reform and break up Fannie Mae and Freddie Mac. They took excessive risks because they knew they would get bailed out (moral hazard) because they are government charted institutions.

(5) No more having the government "asking" banks to support more home loans which yielded sub-prime loans which are a big reason for the mess we are in now.

(6) Some of the weakest banks will have to be allowed to go under. Where to draw the line is a tough one though.

(7) The current government holdings in banks should be liquidated as soon as the crisis is over.