If Banks Can't Borrow, They Can't Fail

In 2008, as financial titans bit the dust, no US official dared to say the D-word. It was economically incorrect. Even whispering it could trigger more bank runs. So President Bush, Henry Paulson, the Treasury Secretary, and Ben Bernanke, Chairman of the Federal Reserve, kept “depression” at the back of their tongues.

Today the D-word is sanctioned. President Obama, Tim Geithner and Mr Bernanke say that they’ve saved Wall Street and Main Street: “Our patients are weak, but they’ll fully recover. It could have been worse. Depression was just around the corner. Good we came when we did.”

This may reassure some. To me, it’s highly alarming. The reason is simple. The Administration has treated the symptoms, not the causes of our financial plague.

This scourge will not be eliminated by taxing Wall Street or the City, which will shift the tax on. Nor will it be fixed by restricting bonuses, which can be paid in other forms, or by telling Wall Street or the City to move their gambling out of public sight or that (wink, wink) taxpayers will never again cover the banks’ gambling debts.

Deadly, but highly operable, cancer calls for surgery. That’s the safe option. Applying sticking plasters and praying for remission: that’s truly dangerous. The financial tumour is clear. It’s the web of financial, regulatory and political malfeasance that caused the financial meltdown. Hucksters systematically sold trillions of dollars of fraudulent securities to unsuspecting people across the globe.

And it was all done under the noses of regulators, each vying for the title of Inspector Clouseau.

Thanks to the system’s policy of full non-disclosure, a $2 trillion US scam turned into a $30 trillion global meltdown. No one knew which securities were toxic. Consequently no one trusted financial companies or any of their products. This non-disclosure endures and could easily take down even a bank as big as J P Morgan.

Millions lost their jobs, savings and confidence in the financial sector. Without that trust, the Great R could, with one more financial tremor, become the Great D.

Uncle Sam’s financial guarantees now total $24 trillion. The Federal Deposit Insurance Corporation alone backs $6 trillion in current accounts with essentially zero reserves. If there was a run on American banks, Uncle Sam would have to print those $6 trillion, causing hyperinflation, which would trigger the other $18 trillion in guarantees, meaning trillions more would have to be printed, causing even more inflation. Anyone not running for their money to buy something real would end up with worthless cash. Uncle Sam’s dirty little secret is that he’s guaranteeing pieces of paper, not purchasing power.

There is a simple, quick way to restore integrity to the system — Limited Purpose Banking (LPB). It makes banks, insurance companies and all other financial corporations operate as mutual fund companies (unit trusts) called LPB banks. Mutual funds don’t borrow short and lend long. They don’t borrow at all. They take in funds on a 100 per cent equity basis (they sell shares) and use these proceeds either to make loans by purchasing mortgages, commercial paper (short-term IOUs from companies) and corporate and government bonds or to buy stocks.

Neither LPB banks nor the individual mutual funds they operate, are allowed to borrow, full stop. Hence, they would never experience a bank run. Under LPB, households manage their own risk by choosing from safe or risky mutual funds.

The individual funds can be viewed as small banks, each with a 100 per cent capital requirement. This ensures that when a fund invests poorly, it doesn’t infect anyone else.

Will this work? It has! We’ve just had a huge financial earthquake and the only part of the system still standing is the mutual fund industry, which, in the US, constitutes a third of the capital market.

Under LPB, a single regulator (in the US, the Federal Financial Authority) would fully disclose on the web what the mutual funds are holding. It would also verify the credit histories, income and third-party custody arrangements of all mutual fund securities. And it would hire multiple, non-conflicted companies to rate the securities and collateral. This provides honest, independent assessments of the securities we’re buying.

Here’s how it would work for the Smith family seeking to buy a house. The bank would take their mortgage application and have it verified by the regulator. This includes using tax return data to check that they are accurately reporting their income and hiring appraisers to assess the market value of the home they want to buy. The regulator would verify the Smith’s credit history and have the mortgage application independently rated. Finally, the regulator would publish the application on the web, without revealing the Smiths’ identity. At this point the LPB bank would put up the loan for auction and purchase by its own mutual funds or those of other LPB banks. LPB auctions ensure that individuals and businesses can borrow at the lowest rate and that corporations get the highest price for the equity they issue.

Insurance mutual funds would be closed-end funds with fixed end dates. All proceeds would be invested in Treasury bonds that come due at the end date. At that time, the pot — the value of the Treasuries less the fee charged by the fund — is paid out to the winners.

If the fund is providing life insurance, the winners are those who die; they (their survivors) get the pot in proportion to their shares. If the fund is providing home insurance, the winners are those who experience properly adjusted flood, fire and theft claims. They get the pot in proportion to their shares weighted by their losses. If the fund is insuring against company X defaulting on its debt, the winners, if default occurs, are those who invested on that basis.

No matter if the bet is on living, dying, medical costs, the economy tanking or house prices falling, the winners take the pot and the losers have no claim on taxpayers.

The issue is setting up a system that’s honest, transparent, competitive and safe at any speed. The collapse of so many financial behemoths flipped the global economy from a good to a terrible equilibrium. LPB will end our financial plague before it strikes again by providing something that no money can buy — trust.

Laurence J. Kotlikoff is Professor of Economics at Boston University and author of Jimmy Stewart Is Dead — Ending the World's Ongoing Financial Plague with Limited Purpose Banking

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