Wednesday, February 17, 2016


The Federal Reserve Bank of Minneapolis seeks comments on how to end "Too Big To Fail".

A friend suggested I submit something, so maybe I'd be heard.  So, here goes.  I am simply submitting a link to this blog post:

I've written before how to do this conceptually, but here I'm giving slightly more detail:

Banks engage in two unrelated businesses:
  • Banks make loans;
  • Banks accept demand deposits.
We only think these activities are related because that's how banks have always worked.

TBTF status arises because banks currently face a mismatch between demand deposits and loans.  You can't call all the loans to return cash to depositors.  FDIC works for small, idiosyncratic risks of bank failures.  Not giant or systematic ones.  If we separate those activities, we shall see that the companies that accept demand deposits cannot fail and the companies that engage in lending fail to the detriment of their risk taking investors, not the public.

Three simple steps separate these activities:

First, Allow anyone to own a bank with 100% reserves.

Regulations today put severe restrictions on who can own banks.  For the most part, non-financial companies cannot own banks.  Regulators worried that bank deposits might end up supporting non-bank operations.  Additionally, lending to competitors of the non-bank company might lead to anti-competitive behavior.  (Imagine you made a loan to your competitor widget producer, and threatened to call the loan if they lowered their prices below yours.) 

Now suppose you had a special class of bank that did not make loans.  This bank held physical currency, Treasury securities and reserves as the Fed.  This bank only deals in demand deposits and riskless securities.  This bank cannot lend to companies or people.  This bank cannot have a run.

This bank is not very profitable.  This bank makes money on the spread between interest paid on reserves, Treasury securities and transaction fees.  It might pay interest, depending on expenses.  Who engages in this seemingly capital intensive, not very profitable business?  Walmart, Target, Home Depot, Costco immediately start banks.  They have stores full of tellers and cash.  Currency is simply a product they already carry in their stores.

Second, Modify FDIC pricing

 FDIC protects bank customers from bank runs.  Because it protects bank customers, it protects bank shareholders.  FDIC (and the risk of exceeding FDIC limits) are the source of TBTF.  Bank customers treat bank deposits as riskless because they've been trained by FDIC to believe it.  Corporate (and very wealthy) customers with deposits exceeding limits do not have a riskless alternative EXCEPT TBTF.  If my company's payroll is $100 million a month, where do I put that cash so that it is absolutely safe?

New FDIC rules say banks with 100% reserves do not have to pay for FDIC insurance.  Note: I'm not saying (right away) eliminate it.  That would not be perceived well by the public.  But, it's free.  Because FDIC has no risk.

(Eventually, FDIC goes away.  Or, maybe, since FDIC is much smaller than the industry of banking oversight in general, FDIC becomes the official organization that looks at a bank's balance sheet for about 10 minutes a quarter to say: Yup, you have no loans, and your cash plus Treasury securities plus reserves at the Fed equals your deposits.  You're good to go!)

At the same time, ramp up FDIC insurance pricing quickly to banks with less than 100% reserves.  Price increases will control the speed with which we separate demand deposit management from lending.  FDIC transitions from an insurance handout encouraging TBTF to a painful tax on commingling demand deposits and lending.

What happens to the existing banks?  They restructure into a banking subsidiary managing deposits and an investment manager running mutual funds, (because in the next step we kill money market funds!)

Third, eliminate money market fund pricing exemptions

Money market funds exist to deceive the public.  I'm not overstating this in any way.  If we remove the exemptions that allow money market funds to manipulate their net asset values so they look riskless, then the public will understand that bank deposits (in a 100% reserve bank) have no risk, but that money market fund's share price bounces around a little because it is risky.  The money market fund is pretty darn available for withdrawal, but the price moves.

Under these circumstances, the saving and investing public makes clear distinctions between storing money in a way that is always available (saving), and lending money for risk taking purposes (investing.)

I suspect this third step would be the end of money market funds.  Money market funds would become ultra short term bond funds...because that's what they are without the regulations designed to deceive us.  At that point, however, there would be no reason NOT to let them fail.  You, the investor took a risk.  Too bad.  You had an alternative.