Fixing Our Failed Fractional Reserve Banking System

Last week in "A Fetid Fable of Fractional Reserve Banking" I shared a thinly disguised fairy tale about the creation of the Federal Reserve and its power to take money from hapless taxpayers and hand it to politically connected bankers. Reading between the lines my editor falsely accused me of supporting a ban on fractional reserve banking, a draconian solution that throws out the good along with the bad. This begs the question, if you don't want to end it how would you mend it?

Here's my recipe: Use proper accounting disclosure standards to make the difference between insolvency and illiquidity transparent, let insolvent banks that become illiquid fail just like any other business, let speculators and cash-rich corporations step in to support solvent banks that have short term liquidity problems extracting whatever price the market will bear, and let a bank's equity holders first, debt holders second, and depositors third carry the risk of imprudent lending policies without explicit or implicit guarantees of a taxpayer bailout or phony government insurance, thereby eliminating moral hazard while aligning the goals of all the stakeholders under a regime that should make credit available to the creditworthy while keeping the unworthy away from debilitating debt.

Whoa, that was a mouthful. Let's start this column over.

Once upon a time there were two banks - Angel's Trust and Devil's Bargain. They both raised $100M in capital, garnered $300M in deposits, sold $100M of long term debt to bondholders, and originated $450M in loans.

Neither bank could pay off their depositors if they all showed up at the teller window.

Angel's Trust hired conscientious loan officers, meticulously reviewed applications, demanded collateral, only approved home mortgages if buyers put 20% down, held on to those mortgages through maturity, and quickly foreclosed on delinquent borrowers. Angel's profits were modest but steady, enough to pay dividends to its shareholders as well as a healthy but not unseemly bonus to its CEO.

Devil's Bargain was staffed by used car salesmen, paid them a commission for every loan they originated, never bothered reading applications, demanded no collateral, specialized in no-money down liars-loans, bundled mortgages into bonds they unloaded on other used car salesmen run banks, and took out radio ads boasting that they never foreclosed on anyone. For a few years Devil's reported soaring profits, making it easy to lavish eye popping bonuses on its CEO.

One day a bad fright caused a depositor run on both banks. Under today's regime Uncle Sam would bail out both banks using your paycheck and mine, demonstrating that maintaining sound lending practices is for suckers. Angel's Trust would recover earning a modest profit for its rescuers that would be touted in front page news while Devil's Bargain would quietly be wound down at a loss of hundreds of millions of dollars after its millionaire CEO moved on to a job in Washington.

Sound familiar? So, how would our two banks fare under the regime proposed above?

Hedge Fund Harry followed both banks, scheming to profit should they stumble. His analysts calculated that Angel's Trust strong and diversified loan portfolio would stand up under stress. He was disappointed when his bid to extend a short term credit facility was undercut by two competitors along with a mixed debt/equity offer from AmaGoogBay.com, but he lowered the origination fee and interest rate as well as the warrant coverage and won the deal. News of the cash infusion settled depositors and within a month everything was back to normal. Angel's Trust eventually closed out the credit line, thanked Harry for his confidence, and Harry bought himself a Tesla Roadster to celebrate his good fortune.

Harry's analysts also told him that Devil's loan portfolio was worth maybe $300M, and only if properly managed. Devil's was not just illiquid, it was insolvent. Sensing the kill he called around to Devil's major stock and bond holders and gave them an ultimatum. Accept a cram down recapitalization, give outstanding bonds a stiff haircut converting them to common stock subordinated to new convertible preferred shares, and appoint me chairman of the board with the power to replace your CEO. If you don't like that go try your luck with the bankruptcy judge.

After news of Harry's machinations leaked out capitulation came within hours. It took several years of hard work but the new CEO replaced the management team, restructured some of the non-performing loans, foreclosed on others, kept depositors whole, nursed the bank back to profitability, and sold it to Angel's Trust for a tidy profit. This time Harry bought himself a yacht where he sat on the deck telling tales of the times he lost his shirt when things didn't go this well.

Devil's former CEO spent the rest of his life defending himself against shareholder lawsuits. Devil's original investors that weren't flushed out of the business learned to pay more attention when investing in banks. Devil's depositors got a good scare and from then on were more careful about putting their money in shaky banks promising higher interest rates. And taxpayers never had to march on Washington with torches and pitchforks to defend themselves from a bankrupt government that thinks the solution to every problem is higher taxes.

So, which will it be?