By Laurence Kotlikoff
Dear John,
I read with great interest your terrific speech about banking reform. I agree with essentially everything you said, but want to take issue with some aspects of your brief remarks about Limited Purpose Banking.
In your remarks, you lump Narrow Banking together with Limited Purpose Banking, but they are very different proposals. Limited Purpose Banking includes Narrow Banking insofar as cash mutual funds would be held strictly in cash. Such cash mutual funds would be used as the payment system under Limited Purpose Banking and would be the only mutual funds that would be backed to the buck. All other mutual funds, whether open end or closed end, would float in the market.
Narrow banking invites all the problems of shadow banking (non-bank banks) to which you properly elude. In lumping Narrow Banking together with Limited Purpose Banking, you seem to suggest that the problem of shadow banks would arise under Limited Purpose Banking as well.
That’s not the case. Under Limited Purpose Banking, there are no incorporated shadow banks because all incorporated financial companies, whether they call themselves commercial banks, investment banks, hedge funds, SIVs, insurance companies, etc., are forced to operate in one way only — as mutual fund companies, which issue mutual funds with absolutely zero leverage, including no short positions.
How does Limited Purpose Banking keep leveraged shadow banks from emerging? It does so by drawing a strict line based on liability — between financial companies that wish to operate with limited liability and those that choose to operate with unlimited liability. Financial companies that want to operate with limited liability are permitted to operate in one way only – as 100 per cent equity-financed mutual funds.
Financial companies that choose to operate with unlimited liability, such that every pound their owners possess can be completely lost if their companies’ debts exceed their assets, are free to borrow. Such unlimited liability banks would likely be a very minor component of the financial system. I doubt that the “brilliant” titans of Wall Street who produced the financial debacle would have done so had their homes, villas, yachts, Austin Martins, etc., been on the line.
Under Limited Purpose Banking, financial corporations are free to engage in other activities besides sponsoring mutual funds as long as those activities do not involve leverage. Thus, investment banking would become a pure consulting business and trading would become a matching business with zero exposure at all times.
I hope this puts to rest your concern that shadow banks would arise under Limited Purpose Banking.
You are also, no doubt, concerned about the government having to bail out mutual funds. We saw this problem with the money market funds, which claimed to be backed to the buck. But under Limited Purpose Banking, nothing would be backed to the buck except cash mutual funds, which literally hold a buck for every buck invested. The first page of the prospectus of every non-cash mutual fund would contain only one sentence, in huge type, and require the investor to sign an acknowledgement at the bottom. The sentence would read: This investment is risky and can break the buck.
Furthermore, no mutual fund company would be permitted to use its own resources to back the buck of any mutual fund. Hence, people would quickly witness some money market funds breaking the buck and learn that such mutual funds have no more claim to a bailout than a stock fund.
In the US, the mutual funds hold $11 trillion in assets. Most Americans do most of their saving/investing/banking through their 401(k) and other retirement accounts, which are almost exclusively invested in mutual funds. Ordinary Americans are very used to seeing their equity and bond mutual funds break the buck. But if a financial institution claims, as the money market mutual funds did, that they are guaranteeing no loss of principal, people will scream when that guarantee is not fulfilled.
Now, let me now turn to my second concern. In referring to Limited Purpose Banking you say: “But to ban the funding of ordinary credit by deposits could have considerable economic costs.”
I respectfully disagree. Since money is fungible, we can’t say whether short-term deposits or other forms of bank borrowing, including long-term borrowing, are financing ordinary credit, which I take to mean mortgages and loans to small and medium size businesses.
What we can say, from looking at the mortgage market in Denmark and other countries, is that short-term deposits are not needed to finance ordinary credit. As I understand it, virtually all mortgages in Denmark are funded by long-term covered bonds. Apart from the fact that these bonds don’t bear credit risk, they are essentially identical to closed end mutual fund shares., i.e. the Danish mortgage finance system is very close to the closed end mutual fund system of mortgage finance, which I discussed in Jimmy Stewart Is Dead and, recently, in a Bloomberg column.
The use of covered bonds to finance mortgages dates back over 200 years. Sweden, Germany, and, recently, New Zealand and Australia, are examples of other countries, in addition to Denmark, that finance ordinary credit without relying on deposits.
In the US, there are 8,000 mutual funds investing in all kinds of securities, including mortgages. Under Limited Purpose Banking, all mortgages as well as all short, medium, and long-term loans to business, whether small, medium, or large, would be funded by mutual funds.
But there is a critical feature of Limited Purpose Banking that you didn’t reference that is essential to making this equity finance of borrowing work, namely the establishment of a regulator, which I call the Federal Financial Authority, to hire private companies, who work only for it, to verify, appraise, rate, and disclose on the web in real time and in fine detail all the securities purchased, held, and sold by the mutual fund companies.
The purchase and sale of these securities would occur in daily auctions run by the Federal Financial Authority ensuring borrowers the highest price for their paper and thus the lowest interest rate. I think this system would permit households and small businesses a much lower cost and fast way of selling their paper in the market.
My third concern is your referring to Limited Purpose Banking as “radical.” This word has negative connotations. Many people might infer that moving to Limited Purpose Banking is extreme and dangerous. On the contrary, maintaining the current financial system or anything close to it must be viewed as extreme and dangerous given that it came perilously close to total collapse and still bears that risk. Limited Purpose Banking is the safe move since it rules out, once and for all, financial sector collapse, with the terrible economic costs financial collapse engenders.
Finally, you pinpoint with marvellous clarity the problems with the current system and make clear that a lot more equity is a key part of the solution. But can we really get more equity and, as important, real transparency while maintaining the current system? We’ve seen the Dodd-Frank bill, which left the current system and its terrible dangers largely in place. Wall Street has done it again.
John, the patient is on the table. He needs “radical” heart surgery, not bandaids. You need to operate.
With deep respect,
Larry
PS: Economists have an obligation in proposing policy reforms to disclose any conflict of interest. In this regard, let me indicate that I have none. I do not work for any mutual fund company nor have I been asked to work for any mutual fund company in the future. I consulted for Fidelity Investments for one afternoon roughly 15 years ago. This is the extent of my past work for mutual fund companies.
PPS: Let me also use this opportunity to provide to the public my response to the Independent Banking Commission’s Call for Evidence.
Laurence Kotlikoff is William Fairfield Warren Professor at Boston University
Disclosure: Martin Wolf, the FT’s chief economics commentator, is a member of the Independent Commission on Banking
Related links:
Vickers puts big banks on notice – FT
Banks pull out stops to fend off deep reform – FT
