August 27, 2010

By Michael Prowse, Senior Visiting Fellow

In a press article this week, Sheila Bair, chairman of the Federal Deposit Insurance Corporation, argued forcefully that the key to preventing future banking crises lies in higher capital requirements, as proposed in the Basel III negotiations. It was excessive leverage that got banks into trouble and supervisors must impose tougher controls.

Given the way that banking is currently structured, Ms Bair is almost certainly right. It seems that bank directors cannot be trusted to run their businesses sensibly. In good times they take excessive risks in pursuit of sky-high profits (and bonuses); in bad times they rely on tax-payers to bail them out.

At all times, depositors are so lacking in confidence that public institutions such as the FDIC have to guarantee the safety of deposits. We are presented with a seeming paradox: a macho industry that claims to believe in personal freedom and the profit motive, and yet which is unable to function without subsidies, guarantees and intrusive supervision.

But could banking be differently structured? Could the rules be changed so as to eliminate the possibility of banking panics and systemic crises as well as the necessity for such artificial props as lender of last resort facilities, deposit insurance and capital requirements? Could we, in short, turn banking into a “normal” industry – that is, one in which banks can fail without threatening the stability of entire economies and in which executives can be left to pursue profit without being second-guessed by regulators?

Some leading economists do believe it is possible, but it would mean the end of banking as we know it. For instance Professor Laurence Kottlikoff of Boston University has outlined an ambitious reform that he calls “Limited Purpose Banking” (LPB)*. Many US academic economists have praised his plan, but it has not yet received the attention it deserves from the Obama Administration or Congress.

In the UK, Mr Mervyn King, the governor of the Bank of England (and a respected academic economist), has signalled that he regards LPB as a promising long-term approach to banking reform. Mr King’s interest in radical reform reflects his dismay that the UK government had to bail out over-paid bankers at huge cost to the taxpayer.

But why is banking both so profitable and so fragile? The answer is that bankers, uniquely, are allowed to make contracts they know they may not, in aggregate, be able to honour. When people deposit money in a checking account, they typically think the bank is looking after “their” money. In fact the bank acquires the money and can use it as it pleases, subject to general banking regulations. The bank simply has a contractual obligation to return the same sum of money when demanded.

The bank makes similar contracts with many other depositors. Yet at any given time, its immediately available cash may represent only 10 per cent of the value of its checking accounts. In other words, if everyone wanted to enforce their contracts simultaneously, the bank could satisfy only 1 in 10 of its customers.

The rest has been lent out for longer time periods or invested in risky assets in the hope of making profits for shareholders and lucrative bonuses for staff. The rules thus permit banks to gamble with depositors’ funds while all the time pretending the money is there whenever required. As we discovered in 2008, sometimes it is not there.

Under LPB, by contrast, banks would not assume ownership of funds that are deposited with them. They would become pure financial intermediaries or “middlemen”. Savers’ funds would not be invested or lent except on terms expressly agreed by the savers. This may sound impossibly complex. But it is really very simple because it just requires banks to become administrators of mutual funds, and cease to lend or invest in their own name.

The mutual fund industry has operated in parallel with banks for 60 years. It is a hugely successful and highly stable industry. More than $12 trillion is invested in 8,000 or so funds which offer investors every possible combination of risk and return across the entire spectrum of financial assets. In the recent financial crisis Goldman Sachs, the bluest of blue chip investment banks, would have gone bust without taxpayer support. But did anyone hear of trouble at a big mutual fund such as Fidelity?

The difference is that mutual funds handle their clients’ money in a wholly transparent and accountable fashion. If I put money in a bank I have no idea how it will be used. It might be lent out as a mortgage, or loaned to a small business, or invested in emerging markets or spent on credit default swaps.

But if I invest in a mutual fund I must choose between a bond fund, a real estate fund, a commercial paper fund, an equity fund and many others. If I choose a risky fund I know I may lose my investment. But my loss does not imperil the mutual fund because its profits are derived from commissions rather than from position taking in its own name.

Under LPB, banks would join the mutual fund industry. They would become administrators of a wide variety of funds into which they would channel their clients’ money. If an individual wanted a checking account, the bank would put their money into its cash mutual fund, which would be entirely safe because it would be 100 per cent invested in cash.

If a homeowner wanted a mortgage, the bank would agree the terms, have them vetted by a rating agency (a federal body in Mr Kottlikoff’s plan), and then sell the loan to one of its funds that invests in mortgages. The home loan would thus be an asset not of the bank but of investors in one of its mortgage funds.

If a company wanted a loan, the bank would agree terms and sell the loan to one of its funds specialising in commercial paper. If a company wanted to raise additional equity, one of the bank’s equity funds would buy the required stake. Again, it would be investors in the bank’s commercial paper and equity funds, rather than the bank itself, that would own the loan or equity stake.

In theory at least, Limited Purpose Banking would eliminate the need for lender of last resort facilities, deposit insurance, and capital requirements. Regulators could go home. There would be no possibility of bank runs for the same reason there are no mutual fund runs. No false promises would be made: a cash fund would be fully invested in cash: the money always would be there if required. Banks would not have to meet capital requirements because taking commissions on the management of mutual funds is not an especially risky business.

Mr Kottlikoff may sound like a kill-joy. But he does not oppose risk taking. Any individual, including highly-paid bankers, would be perfectly free to make as risky an investment as they please. They could still take direct stakes in start-up companies, or extend mortgages to people unable to service them, or dabble in derivatives and credit default swaps.

The difference is that they would have to invest their own money. They would no longer be free to gamble with depositors’ money, confident that if things go wrong taxpayers will finance their bonuses and share options.

Of course, LPB is not without potential flaws. A transition to transparent banking on the mutual fund model would need careful planning and might take decades to accomplish. It would require political leadership of the highest order to overcome the opposition from banks, which would fight to keep their extraordinary privileges.

Some sceptics will argue that economic growth would collapse without traditional banks. The supply of funds for risky projects is adequate, they say, only because banks do operate in such a murky fashion. Bank executives are willing to take much greater risks than depositors precisely because they are not lending or investing their own money.

At early stage of economic development, when the public has no investment expertise, this argument might be valid. Traditional banks, fractional reserves and so forth might well be necessary. But is that still true today? When there are already 8,000 mutual funds, can it really be said that savings cannot be mobilised unless banks take risks on behalf of individuals, and without informing them of how they are using their funds? Do we still need this kind of paternalism?

A more sophisticated objection, levelled by Adair Turner, former chairman of Britain’s Financial Services Authority, is that the Kottlikoff plan would either not address or perhaps even exacerbate the primary source of financial instability, which is volatility in the supply of credit in response to asset price movements.

As house prices rise, he suggests, people would pile into mutual funds investing in mortgages, increasing the supply of funds for home purchase. House prices would eventually reach an unsustainable peak and begin falling. At that point investors would sell mortgage funds, causing a violent contraction of housing finance, and accelerating the decline in house prices.

Such volatility is certainly possible. But could millions of individuals making independent decisions as to whether to invest their own money in mutual funds really make a bigger mess than a much smaller number of highly paid bankers who are gambling with other people’s money? Remember bankers nearly destroyed the US economy. In all probability, if banks operated like mutual funds, the supply of cash to unsuitable borrowers would have been better controlled, and the housing bubble less pronounced.

At present, Limited Purpose Banking is just a theory. Nobody knows if it could really work. But Mr Kottlikoff’s ideas have been favourably reviewed by leading liberal economists such as Jeffrey Sachs and George Akerlof, and by prominent conservatives such as Robert Lucas. Banking as currently constituted is such a dysfunctional industry – so inequitable, so inefficient and, frankly, so dangerous – that policy makers ought at least to investigate possible alternatives.

*Jimmy Stewart is Dead – Ending the World's Ongoing Financial Plague with Limited Purpose Banking. John Wiley and Sons, 2010.