Sunday, January 10, 2010

Financial regulation in three easy steps! Here's step one...okay, and two...

No, I did not receive a call from Bernanke, Geithner or Obama.  But, I'm still willing to put forth my solution.  We need three key changes.  But I'm confident they'll solve all our problems!

Step 1: Eliminate fractional reserve banking. Oh, and kill the bank holding company restrictions.

I give Terence bonus points as both the first commentator on one of my postings, and for his excellent recall of college economics!  As well all learn as kids making our first deposits, no, the bank doesn't have the cash in the vault to cover all deposits.  But, there's nothing to prevent that!

We can suppose in the early days of banks, record keeping, security, tellers, etc. combined with limited liquidity and access to "safe" government bonds made 100% reserve banking essentially impossible.  Banks needed a way to earn a significant spread between deposits and loans in order to exist.

Today, its very hard to define what a bank is.  From the customers making deposits, a bank handles cash management, storage and transaction processing, whether this is via debit card, ATM cards, online or tellers.  Frankly, depositors for the most part don't care what goes on in detail because FDIC covers their collective asses.  The borrower customer sees a different experience.  They see lenders who are subsidized by the government who make them loans, (at rates they invariably think are too high because they're depositors too, and they see the spread first hand.)

Then, there are the shareholders!  They see FDIC giving them free calls all day long!  No wonder banks blow up.  Sure, management teams may give screwy incentives to lending officers.  No worse than FDIC gives to management!

So, let's redefine what a bank is.  A bank only handles cash management exercises.  They take deposits, process cash, clear checks, provide ATMs, debit cards, etc.  And, they hold customer deposits in cash and T-Bills.  Maybe I'll go crazy and agree they can go out to two year maturities.  Probably not.

So, banks become entirely transactional.  They only pay interest on deposits when, after the expenses of processing transactions, running their branches, etc., and their margins, there's money left over.  This would be a very low return business, but ridiculously low risk as well.

The second piece of Step 1 comes here: Bank Holding Company Act...see ya'.  Bank holding companies (this is the magical entity that holds a bank operating company) says there are crazy rules about who can control a bank.  They've got to be honest citizens who subject themselves to a regular financial colonoscopy.  Oh, and they cannot also own a regular operating company that makes stuff or sells stuff.

This may come a surprise, but Walmart tried for years to have a bank.  Utah had a great regulatory regime.  Something called a business bank, as I recall.  Says an operating company can own a bank, as long as it doesn't take retail deposits.  And it had lending restrictions.  Why the rules?  You wouldn't want your primary competitor in your manufacturing business to all of a sudden control your banking relationships because they bought your bank.   Bad news.

So, once a bank can't lend money, and a bank has 100% reserves, you don't have these conflicts.  And, you don't have the risk that their "other businesses" bring down the bank.  The bank operating company would be isolated from anything else.  Full deposit coverage in the form of cash, reserves and Treasurys.

In this regime, who owns banks?  My best guess: Visa, Mastercard and Cirrus each become banks because they are the networks that are processing transactions.  I bet IBM and Oracle become banks because they're already the software that is banks.  Walmart, Sears, Costco become banks.  Citigroup and J.P. Morgan dump their storefronts and networks into a new bank.  Microsoft maybe.  You see where I'm going.

FDIC goes away.  No need.  Banks fully covered.  Fraud that causes them not to be covered dealt with through private insurance.  Regulation of banks (feet on the ground regulation) for all practical purposes is gone.  Ninety seven percent less work to do.

Now that banks cannot fail, and don't need much regulatory oversight, we've addressed the biggest problem of financial disaster: mom and pop lose their cash.

Step 2:  Non-bank financial institutions must raise their equity capital under tight constraints.

See this post...see, I told you this was easy!  I promised step one, but we've already cleared to step two!

If non-bank financial institutions (what we now call investment banks, specialty lenders, whatever) cannot raise outside equity capital, that substantially reduces managment's ability to own calls on other people's equity, and fundamentally addresses "too big to fail" because they won't get nearly as big.

You'll have to hold your breath for Step 3.  This will address insurance companies because I distinguish them from banks and non-bank financials.  For now, let's say the problem is that they need too much money to work the same way as non-bank financials.

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