Monday, March 2, 2009

Let’s revive the radical idea of narrow banking

From Naked Capitalism:

"In Praise of More Primitive Finance"

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Analysts, regulators, and politicians are beginning to recognize that most if not all of the widely touted benefits of modern finance redounded only to its purveyors. The decidedly retro Canadian banking system, with simple products, high equity requirements, and relatively modest securities operations that focus on domestic customers, is the soundest in the world. As Theresa Tedesco noted in the New York Times:
The five major chartered banks, the few regional banks and handful of large insurance companies are all regulated by the federal government. Canadian banks are relatively constrained in the amounts they can lend. Canadian banks are required to have a bigger cushion to absorb losses than American banks. In addition, Canadian government regulations protect the domestic banks by limiting foreign competition. They also keep banks broadly owned by public shareholders....

Canadian banks are known to be risk-averse, and this has served them well. While their American counterparts were loading up their books with risky mortgages, Canadian banks maintained their lending requirements, largely avoiding subprime mortgages. The buttoned-down banks in Canada also tended to keep these types of securities on their books, rather than packaging them and selling them to investors. This meant that the exposures they did have to weak mortgages were more visible to the marketplace.

The big five Canadian banks — Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Canadian Imperial Bank of Commerce and Bank of Montreal — survived the recent turmoil relatively unscathed. Their balance sheets remain intact and their capital ratios are comfortably above requirements.

Columbia University professor Amar Bhide, writing at the Berkeley Economic Press, endorses the idea of a reinstitution of simpler banking practices. The first part of his article offers an insightful, in many respects novel, critique of how we got in our mess. Bhide sees it as long in the making:
The financial debacle— the first to implicate the widespread use of complex financial instruments, rather than simple speculation or imprudent lending— isn’t just the result of the recent missteps of bankers, rating agencies or mortgage brokers. Rather, finance has been on the wrong trajectory for more than half a century. Its defects derive from the academic theories and regulatory structures that have evolved since the 1930s—dysfunctional foundations that have not drawn the scrutiny they deserve. And without addressing the deep defects, we are likely to lurch from crisis to crisis.

His recommendation is straightforward:
Reversing many age-old dysfunctions isn’t likely. We aren’t going to retrain business school processors in the art and science of traditional fundamental analysis or due diligence. Nor is repeal of the Securities Acts or the reprivatization of financial firms on the cards.

We could, however, go a long way to limiting future meltdowns by a simpler more primitive regulatory regime that keeps banks from enabling dangerous and opaque schemes.

Let’s revive the radical idea of narrow banking and tightly limit what banks (and any other entities that raise short term deposits from the public) can do: nothing besides making loans—after old-fashioned due diligence— and simple hedging transactions. The standard would simply be whether the loan can be monitored by bankers and examiners who do not have PhDs in finance.

Anyone else: investment banks, hedge funds, trusts and the like can innovate and speculate to the utmost, free of any additional oversight. But, they would not be allowed to trade with or secure credit from regulated banks, except through prudent loans whose collateral and terms can be monitored by run-of-the-mill bankers and examiners.5 This simple, “retro” approach—a more stringent Glass-Steagall Act—would protect depositors, limit the risks of financial contagion, allow the FDIC and Fed to focus on their primary responsibilities, and not require new agencies or more regulators. Less, would in fact, be more.

Speculations and bubbles would not be eliminated, but walling off the banking system would limit the extent of collateral damage. When the internet bubble burst, for instance, nearly half a trillion dollars of wealth evaporated. But because very little bank lending was involved the impact on the economy as a whole was modest.

Some would, of course, lose. Money market funds would lose their free ride—the howls of protest emanating from money market funds at proposed rules that they take some responsibility for their investment choices6 are telling. Financial engineers would lose access to cheap credit—alarming those who claim that the “sophistication” of the U.S. financial system is a prime cause of U.S. prosperity. But, although a modern economy does need the effective provision of some financial basics, such as risk capital, credit and insurance, claims that all the bells and whistles that have been developed over the last couple of decades are a net plus are implausible. Can we really believe that a financial sector now receives more than thirty percent of domestic corporate profits—double its share from twenty five years ago7—because it has produced improvements in mobilizing or allocating capital of that magnitude?

More likely, innovators and entrepreneurs in the real economy prospered in spite of the talent and funds that were taken up by the expansion of the financial sector. So if the financial sector shrinks back to the basics, so much the better for long run prosperity."


Don said...

Since I'm pushing this idea, here's another good post from the FT:

"This limited purpose banking is a modern version of narrow banking proposed by Frank Knight, Henry Simons, and Irving Fisher. Banks would hold deposits, cash checks, wire money, originate loans, and market mutual funds, including money market funds with no guarantee of par value redemption.

With limited purpose banking, financial crises would largely disappear. Banks would never fail, never stop originating loans, never expose the public to massive liabilities, and never see their stock values evaporate. Banks would be stable, boring economic cogs - like gas stations.

The Fed would also gain full control of the money supply. To expand the money supply, the Fed would continue buying treasuries from the public and supplying cash. But banks wouldn’t be multiplying and contracting M1 (cash plus demand deposits) based on their ever changing decisions about lending deposited funds.

Milton Friedman, who also advocated narrow banking, blamed the Depression on the Fed’s failure to offset the M1 money multiplier’s collapse. In the past year the M1 multiplier has contracted by over 40 per cent, forcing the Fed to double base money. If the multiplier shoots back up, we could see the money supply and prices explode.

What about investment banks, brokerage firms, hedge funds, and insurance companies? What’s their right financial order?

Again, regulate to purpose. Investment banks take companies public and assist in mergers and acquisitions. They shouldn’t be permitted to invest in their clients’ companies. Brokerage firms are here to help us buy and sell assets, not to gamble on spreads. Hedge funds are here to help limit risk exposure. They aren’t here to insure these risks themselves. Finally, insurance companies are here to diversify risk, not write insurance against aggregate shocks.

The FFA and “less is more” limited purpose banking won’t prevent asset markets from occasionally going nuts. But the functioning of financial markets will no longer be in question. Nor will con artists, parading as “financial engineers,” ever again be free to wreak havoc on the nation’s finances and its citizenry.

Christophe Chamley is a member of Boston University and the Paris School of Economics. Laurence J. Kotlikoff is professor of economics at Boston University"

Read the whole thing.

Don the libertarian Democrat

March 2, 2009 10:08 AM

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