The purpose of banking is to put risk-averse savings to work. If corn sits in the silos unused, rather than being planted or consumed, employment and/or wage growth slows relative to what would have been the case if the economy had fully deployed all its resources. But loaning out the corn and leaving the silos empty is inherently unstable. If real estate prices fall 30% and risk-averse savers run to the silos to withdraw their corn, banks cannot sell their loan portfolio at high enough prices to fund withdrawals. Depositors logically race each other en masse to withdraw their corn.
We must hold banks accountable for loans losses, otherwise they will make bad loans. But if we hold banks responsible for withdrawals, they have no choice but to leave corn in the silo available for withdrawals. If they do that, growth slows just as it has.
Luckily there is a low cost alternative: the Fed can print money (IOU corn) to fund withdrawals in a panic, and burn the money when the panic subsides and deposits return to the banks for safekeeping. Contrary to popular perception, the U.S. government made a profit guaranteeing bank deposits in the worst financial panic since the 1930s.
Unfortunately, the Fed never burned the money when the panic subsided. So far, the excess money has sat unused creating neither growth, as the Fed expected, nor inflation, as some conservatives expected.
To the extent loan losses cause a run on a bank, the Fed can inflict those losses on the bank when the losses are actually incurred—often years after a panic. Rather than do so, the Fed tried to hastily assess and inflict losses on banks in the epicenter of the panic, long before it knew what losses would actually be incurred. This mistake by the Fed did a lot more harm than good. It turns out senior bank loans suffered surprising small losses, perhaps 3%, far smaller than the equity cushion held by banks.
Regulations and capital cushions have now reduced the risk of loan loss and withdrawals that taxpayers, namely rich taxpayers, bear through their implicit guarantees of banks. Pushing this risk onto banks has left risk-averse savings sitting unlent. And banks have pushed this risk onto their customers—homeowners—by raising credit standards to reduce risk. As a result, all but the most creditworthy homeowners have been denied the value of credit. With corn left in the silos, employment and wages growth has slowed substantially.