Laurence Kotlikoff, economics professor at Boston University, writes an open letter to Lord Turner, chairman of the UK’s financial regulator, the FSA. Lord Turner examines Prof Kotlikoff’s proposal for a radical reform of the institutional structure for credit extension in a new book, The Future of Finance. This a two-part open letter; the second part will be published on the FT’s Economists’ Forum on Tuesday July 20.
Adair Turner’s Misplaced Concerns About Limited Purpose Banking
Dear Adair,
Your chapter in the just released Future of Finance is masterful. But the very strong concerns you express about Limited Purpose Banking are, I believe, misleading, misdirected, and rather surprising since LPB delivers precisely the reforms you advocate.
Let me respond in italics to the specifics of what you wrote (the bold text) and then indicate why LPB does what you say you want.
Abolishing banks: 100 per cent equity support for loans. Prof Kotlikoff‘s proposal, in contrast, suggests a truly radical reform of the institutional structure for credit extension.
In the US, mutual fund companies already constitute one third of the financial system and facilitate/intermediate a very large volume of lending to companies, governments, and homebuyers. So “truly radical” is a bit strong for my taste. Also, individual mutual funds are, except for the letters used in their name, banks. The difference is that they are safe banks or, if you like, utility banks, which that “truly radical” economist Mevryn King has advocated. They are safe insofar as they are never leveraged in any state of nature. I chose the word “banking” in Limited Purpose Banking to convey the point that we need banks, but ones that stick to their legitimate purpose – financial intermediation, not gambling with the taxpayers chips and the economy’s performance.
The fact that mutual fund companies were exempted, to my knowledge, from any additional regulation under Dodd-Frank means that the US Congress views mutual funds as a safer banking system. Their expansion relative to traditional banks is surely fostered by this bill. (This and the creation of the Consumer Financial Protection Agency are the two features of Dodd-Frank that I like.)
This is not to say that mutual funds in their current form are what I advocate. As I’ve written, no mutual fund, except cash mutual funds, which hold only cash, would be backed to the buck. Open-end funds would have automatic in-kind redemption or closed-end conversion triggers in the face of redemption runs. I’m strongly opposed to the government’s guaranteeing the buck of any mutual fund besides cash mutual funds, where there is no need for the guarantee since the cash is in the vault, physically or electronically.
Lending banks would become mutual loan funds, with investors sharing month by month (or even day by day) in the economic performance of the underlying loans. This is equivalent to making banks 100% equity funded, performing a pooling but not a tranching function.
This is not a real difference with the current system. Under the existing system, investors in banks, be they stockholders or creditors, are sharing, day by day, in the performance of the banks’ underlying loans. Citigroup bonds, for example, float on the market. While it’s true that deposits don’t explicitly float, they do implicitly insofar as when banks fail, taxpayers have to cover the insured deposits. Hence, every day that the performance of a standard bank’s loans change, the value of the contingent liability facing taxpayers changes.
Also, as I discuss in Jimmy Stewart Is Dead, mutual funds with clearly defined sharing rules (a CDO is such a mutual fund) permit the mutual fund shareholders to leverage each other. So tranching is definitely part of what I’m proposing provided the sharing rules among the parties are very simple and clear and there is no liability to any parties beyond the mutual fund owners.
And it would clearly exclude the possibility of publicly funded rescue: if the price of loan fund assets fell, the investors would immediately suffer the loss.
I disagree. As I say in the book, under LPB the government, if it so chooses, can intervene directly to lower interest rates to particular borrowers by buying shares of the mutual funds purchasing their paper. The mutual funds, themselves, would never need to be publicly rescued, but I believe you are referring to the government rescuing particular borrowers who might not otherwise get funded at “reasonable” interest rates.
The most common reason the price of a loan fund falls is that market interest rates rise. But a rise in market interest rates lowers the market price of outstanding bank debt. And, for that matter, it lowers the implicit market value of deposits to the extent that they are going to be withdrawn in the future as opposed to immediately.
You appear to think that the current financial system is delivering safety for the common man because he has the assurance that his checking account is safe. Under LPB, the common man can invest in cash mutual funds or short-term government bond funds, so he can get this same type of safety.
But, with all due respect, you seem to be missing the fact that risk is hitting the common man through the back door — via the potential for job loss, loss of retirement assets, tax hikes, and future inflation.
But it is not clear that such a model would generate a more stable credit supply.
The stability of the supply of credit is, from my reading of the current and prior credit crises, very closed tied to the stability of the financial system. When major financial companies fail, the specter of this flips the economy to a bad equilibrium (coordination failure) of the type described by Peter Diamond and others in which firms expect and, then, collectively create bad times. In addition, the credit market flips to a bad equilibrium of the type described by Stiglitz and Weiss in which lenders expect only bad borrowers and, then, set rates high enough to produce that outcome. LPB ensures that there will never again be financial failures on a small scale, let alone a large scale. As you know, Limited purpose banks can’t go bankrupt since they are 100 per cent equity financed.
As Section 4 argued, a system of securitized credit combined with mark-to-market accounting can generate self-referential cycles of over and under confidence.
Regardless of the accounting rules and disclosure, the market is going to mark assets to market. Lehman’s chief, Dick Fuld, said his assets were very safe and far exceeded his liabilities, but the market said otherwise. So limiting mark-to-market accounting is not really feasible and questioning it (which I’m not sure you mean to) is shooting the messenger.
As for self-referential cycles of over- and under-confidence, it is the bankers, not the individual investors, who are, it seems to me, alternatively gunning the system and running it down. You want bankers to manage financial risk for individuals and the economy. They aren’t to be trusted in this role. I don’t want our children’s economic futures in the hands of the salesmen and lawyers who end up at the top of financial behemoths. Jimmy Stewart, in short, is dead.
But the main factor I feel you overlook in referencing self-referential cycles is the lack of transparency. Your 86-page paper mentions this word only three times and the word disclosure only once. I think the primary reason the crash of 2008 hit with such force was not the fact that housing prices had risen too much due to irrational exuberance (indeed, they fell much less than stock prices), nor that too much credit, per se, was extended, but that too much fraud was involved in the extension of credit. Had Lehman, Bears, Merrill, Countrywide, … been forced to send their mortgage applications to the Federal Financial Authority (the sole regulator I proposed under LPB) to have the applicant’s past income verified (via income tax returns), have the applicant’s current job and earnings verified, have the applicant’s credit rating verified, have the applicant’s proposed collateral (the home to be purchased) independently appraised, have the applicant’s credit rating verified, and have the applicant’s application (his mortgage) independently rated, and had all this been posted on the web in real time, trillions of dollars in toxic loans would never have been originated. It’s the systematic production of fraudulent securities that’s at the heart of what happened. Your chapter mentions the word fraud not once.
This is not to claim that self-referential cycles can’t arise. As we both know from the work of Samuelson, Cass, Shell, Calvo, Farmer, and many others, models with rational agents (what I’d call neoclassical models) can exhibit multiple equilibria paths of asset prices even absent any of the information/coordination issues referenced above. LPB — a perfectly safe banking system in which all securities purchased, held, and sold by the financial intermediaries are independently vetted and disclosed – won’t keep asset prices from moving in what seem to be crazy ways (just consider today’s long-term U.S. Treasury bond prices), but it will stop bubbles spread by lies and crashes spread by panic over fraud. Under LPB, Madoff’s valuation would never had hit $60bn. It wouldn’t have hit 2 cents since Madoff’s fund would have been a mutual fund subject to third party custody and the custodian would have blown the whistle.
And while Kotlikoff‘s loan funds might seem to abolish the maturity transforming bank, with investors enjoying short term access but not capital certainty, investors would be likely in the upswing to consider their investments as safe as bank deposits.
There are thousands of fixed-income mutual funds whose prices fluctuate by the minute. The owners of these funds don’t view them as safe as bank deposits. And under LPB, money market funds would clearly break the buck. Indeed, I would force the mutual fund companies to reference them as short-term commercial paper funds and make every shareholder sign a one-sentence statement in giant letters – “I understand that this is not a cash mutual fund, that it is risky, that it can break the buck, and that I may, therefore, lose the money I invest.”
Investments in loan funds would therefore be likely to grow in a pro-cyclical fashion when valuations were on an upswing and then to run when valuations and confidence fell, creating credit booms and busts potentially as severe as in past bank-based crises.
The picture being drawn here is of the public purchasers of mutual funds seeing returns on fixed income going up and borrowing on their homes to invest more in these funds in a craze to make a few more basis points. But what we know is that households tend to buy and hold, while bankers tend to churn their portfolios. I just don’t see this as a valid objection to LPB relative to the current system.
