What Real Financial Reform Might Look Like

I recently received my copy of Laurence Kotlikoff's new book Jimmy Stewart is Dead. In this book Kotlikoff calls for limited purpose banking. I was initially skeptical of the idea, but I am warming up to it as I read more. My initial fear was that that limited purpose banking would turn the banking system into nothing more than a vault and therefore reduce financial intermediation. However, this is not the case with this approach as banks would still provide financial intermediation through mutual funds. Checking accounts, however, would be fully backed by cash or t-bills. Interestingly, this would eliminate the money multiplier and thus give the Fed more control over the money supply. I still have some questions on this approach, but can see how it could bring greater financial stability. I would love to hear your thoughts on this approach. 

Below the fold is an long excerpt from one of Kotlikoff's articles on limited purpose banking.

Update: Tyler Cowen discusses limited purpose banking.

Limited-Purpose Banking

Strange as it may seem to so many who have grown used to the American financial subculture of the past few decades, the core purpose of banks and other financial corporations isn’t to gamble with other people’s money. That core purpose is instead to connect—that is, to intermediate between—suppliers and demanders of financing. In this respect, banks are no different from gas stations. Gas stations intermediate between suppliers of gas (refineries) and demanders of gas (drivers); they don’t gamble on the price of gas and leave the country exposed to a huge common bet, the loss of which will lead nearly all of them to close down.

To re-establish trust and resurrect our financial system we need to limit banks and all other financial corporations to their original purpose: financial intermediation. Here’s how limited-purpose banking would work.

Every incorporated enterprise engaged in financial intermediation would operate strictly as a mutual fund company and live under a common set of rules. Whether they would call themselves commercial banks, investment banks, trust companies, hedge funds, savings and loans, mortgage brokers or something else would be immaterial. They would all be free to do the same thing—namely, intermediate, and to make a profit by charging for that service, but take no risks with their company’s money.

Banks (shorthand for financial corporations) would sell only two things: checking account services and shares of mutual funds, which hold bonds, mortgages, stocks, private equity, real estate and other financial securities.

Consider first the banks’ checking account operations. In the current system, banks take in customer deposits and are required to keep only 10 percent in reserve against the possibility that customers will demand their deposits back right away. The other 90 percent is, in effect, the banks’ gambling stakes. It is money banks can lend out on risky projects or spend on risky stocks or invest in risky private equity and real estate. If these investments work out, everyone’s happy. If not, well, the bank gets to flip the problem to the FDIC (i.e., to taxpayers), which insures the deposits. If everyone suddenly comes to believe, whether correctly or not, that the banks have lost their money, everyone will run to the teller windows and demand it back. It won’t be there, as it wasn’t there in 1873 or in 1930.

So we have a depository system that’s very fragile because it is exposed to bank runs. Today, the FDIC is insuring close to $4 trillion dollars in deposits, and it’s frankly very scary that it has less than $36 billion (just around 1 percent) in reserve to cover this massive liability. Were all Americans to panic and demand back their deposits, Uncle Sam would have to print up nearly $4 trillion on the spot—a formula for hyperinflation if ever there were one. Sound extreme? It is. But these are extreme times, and the public is getting close to full panic mode.

Under limited-purpose banking, bank runs could never arise. Every dollar deposited in a checking account would be held in cash or U.S. Treasuries, meaning banks would hold not 10 percent reserves, but 100 percent reserves against these liabilities. Banks would always have all of our money on hand, either in cold cash or short-term T-bills.

This is not a new idea. Three stellar economists—Irving Fisher, Frank Knight and Milton Friedman—proposed precisely this treatment of checking accounts, which they called narrow banking.1 They wanted to end bank runs for good and, not just incidentally, also to give the government full control of the nation’s money supply, what we call M1.

As you know, under today’s system the size of M1 depends on how the banks handle their gambling stakes. If they “invest” all 90 percent, and those getting the 90 percent deposit them back into other banks, which then “invest” 90 percent of the “new” 90 percent and on and on, we can get a huge expansion of deposits. We economists call this daisy chain “the money multiplier” because deposits plus cash held by us in our pockets constitute M1. When banks lend or otherwise invest, M1 expands; when they don’t lend, M1 contracts. Friedman and Anna Schwartz plausibly blamed the Great Depression on the Fed’s failure to prevent the collapse of the money multiplier, and with it M1, as banks cut back their lending.

Today, just as in the 1930s, we’re seeing a huge (almost a 50 percent) decline in the money multiplier. This has forced Federal Reserve Chairman Ben Bernanke to expand the monetary base—to print massive amounts of money, in layman’s terms—to stabilize M1. Printing all this money (Bernanke has more than doubled base money over the past year) holds its own risks, of course: If the multiplier shoots back up, we could see the money supply and prices explode.

To summarize, we’ve got a depository system that’s subject to moral hazard, bank runs and wild swings in the money multiplier. In normal times these risks are theoretical; in times of crisis, they tend to ensure that we suffer maximum feasible calamity. It’s not worth the risk, and limited-purpose banking would eliminate all three problems.

Now to the banks’ second job under limited-purpose banking: selling bond, equity and real estate mutual funds. Let’s start with bond funds.

Under our system banks would initiate but not hold loans. Banks would send their initiated loans, whether to individuals (e.g., a mortgage) or businesses (e.g., a credit line), to a new government agency—the Federal Financial Authority (FFA)—which would rate the loans after using tax records to verify the income reported and spot-checking the appraised value of collateral. Once processed by the FFA, the banks would package the fully disclosed, government-rated loans within mutual funds for purchase by the public. Once purchased, the loan would be activated. The public, not the banks, would own the mutual funds and hold the loans.

Banks could borrow money on their own account to buy office furniture, bank buildings and make other investments in their operations, but not to gamble. Banks would never be leveraged because their purpose is intermediation, not gambling. Bank owners, on the other hand—including the owners of holding companies that include banks and other kinds of businesses—would still be completely free to gamble on high-risk investments, but only with their own personal money, not with the bank’s assets.

There is, of course, a clear precedent for government loan rating; namely, Fannie Mae and Freddie Mac’s conforming loan standard. And the idea of securitizing loans within mutual funds isn’t new either. What’s new here is the scope of the rating system, the degree of disclosure and the absolute prohibition against banks taking risks.

Next consider bank issuance of mutual funds that hold stocks, private equity and real estate. Banks would sell shares of the mutual funds and use the proceeds to purchase these securities. The banks themselves, however, would not own any of the securities held within their mutual funds. They’d simply connect savers to investors and collect a fee for the service.

The FFA would audit the books of all publicly traded companies (to insure against any more Enrons), require full disclosure of the private equity and real estate being packaged within mutual funds, and establish a custodial system to ensure that title to all assets owned by mutual funds is secure and verified. Never again would a Bernie Madoff be free to custody his own accounts; i.e., to lie about the actual investments being made with investor money.

What about insurance companies? How do they fit into the picture? And how can we avoid another AIG, which issued $450 billion in insurance policies, called credit default swaps, and spent these premiums on risky investments, holding nothing in reserve against policy claims. Here we would need tight regulation by the FFA strictly limiting what insurers can insure and including aggregate risk clauses spelling out clearly how payouts will be limited in case insurance claims exceed expected levels. We would also need the FFA, not private-sector companies whose own incentives structures may or may not be perverse, to rate the insurance companies.

See his website for more information on limited purpose banking.