A Long-Term, Structural Solution to the Banking Crisis

For years, there have been well-argued criticisms of fractional-reserve banking. The term merely describes the current system in which depositors have a legal claim on all deposited funds, of which only a fraction thereof are held in reserve by the bank in case of withdrawals, the rest being invested by banks in mortgages, loans, etc.

Until recently, few alternatives have been viable. However, financial disintermediation, with funds being held directly by investors, has increasingly become the norm. What would an ideal banking system look like?  How could it maintain the flow of investment dollars into the economy, which banks currently provide? Surprisingly, it might be a natural evolution of the status quo. If embraced by policymakers, evolutionary reforms could be a free market solution to exaggerated booms and busts in the banking system. Increasing risk segmentation and removing leverage could both lower risk and increase the flow of stable investment funds into the economy. More importantly, it would eliminate much of the need for government intervention and the socialization of risk by the Federal Reserve, FDIC, and GSEs, at least in the current form. 

Simply, what would be the underlying philosophy and structure of a viable, realistic, and improved alternative?

Markets should reflect intrinsic value, not excesses or deficiencies in capital. Why not have a special class of closed end funds or REITs which are not allowed to use debt leverage do their own due diligence on high-quality mortgages and invest therein? Such structures could be managed by banks and utilize bank loan officers, while removing leverage from the financial system and providing stable sources of bank fee income. Banks would still be able to actively engage in their current functions of mortgage lending, monitoring payment, and foreclosure management without the attendant risk of leverage.

Then, investors who wish to take mortgage risk can do so, while people who want a simple checking account with low risk can have that as well, with their money kept in a vault, or in non-leveraged, high quality money market accounts in treasuries, AAA corporate, AAA municipals, etc.

In this manner, the insidious grip of leverage is removed from the banking system, and people can choose to only take intentional risks, rather than inadvertent, unintentional risks associated with the current system.

Under the status quo, as we have seen with IndyMac, depositors' savings can be invested in high risk, overvalued real estate mortgages/loans without their knowledge, comprehension, or support.

IndyMac depositors did not consciously decide to invest in high-risk mortgages. However, in economic essence, because the bank took their deposits and turned around and invested in such assets, that is precisely what occurred. If the depositors decided to invest in a closed end fund or mortgage REIT with the explicit understanding that such risks were being taken, that would be acceptable (especially if such structures did not employ debt leverage, as is the current common practice). However, they made no such decision. Most depositors simply wanted a place to store and manage liquid funds and the paying of bills.

The viability of reform really goes back to the theory of the firm, which holds that transaction costs create the needs for certain firms, so that often disparate functions are under one roof. Loan origination can go hand-in-hand with the management of mortgage funds while allowing such funds to be held directly by investors, not a leveraged bank. Why not have a system in which people can buy high quality money market funds, but do not deposit money in banks accounts whose funds are then used by the bank to invest in mortgages? It is the precise dual, simultaneous  use of deposits by banks and the concurrent legal claim on them by depositors which is so destabilizing to the financial system.

Mortgages are long term in nature, while deposits (other than CDs) can be pulled at a moment's notice. Why would we allow a system where short-term liabilities are systematically allowed to fund long-term holdings of investment assets?  

Reserve requirements are a function of the expected liquidity preferences of depositors. That is a fancy way of saying that since psychology and economic stress underlies liquidity preferences, that reserve requirements are least adequate when the financial system is under the most stress.

Therefore, banks are always vulnerable on a structural level to collapse. To say that trust underlies banking solvency and arguing that such a situation is acceptable is rather akin to arguing that trust is sufficient to maintain the safety of skyscrapers, bridges, or tunnels. Structural integrity is paramount, not psychology. 

Policymakers must support robust, high quality structures which promote sustainable growth and stability. The current system does neither. Booms and busts are inherent to all leveraged systems. Banks are no exception.

Fractional-reserve banking benefits neither society, nor depositors, nor bankers. It is important to maintain investment capital in any healthy economy. Leverage in the banking system does not sustain such a flow of capital, but puts it at risk. Non-leveraged structures can provide more robust, sustainable, and less cyclical flows of investment into the economy. Such a system would merely be an evolutionary development from the current trend towards financial disintermediation from banking institutions to individuals, investment funds, and markets themselves.

Segmentation is the increasing global trend of the last century. Why not allow people to explicitly segment their risk tolerance? The system I've outlined above would do that. It would therefore eliminate the need for the socializing or risk in the form of the FDIC. Those who want simple, high quality money market risk can have it, others can have their funds in a vault, and those who wish to take on more risk for a higher yield might do that as well through closed end funds or REIT structures which invest in mortgages.

Thereby, the duration of the investments would be matched by the liquidity constraint, forestalling panics, forced liquidations, and the inefficient, inadvertent taking of uncontemplated risks. Money market mutual funds would invest in short-term obligations, and hence have a mutual fund structure, while closed end funds and REITs could lock in the underlying investments on a longer-term basis, as they do now.

The widespread adoption of industry standards for an unleveraged class of high quality mortgage  REITs and closed end mortgage funds which hold mortgages would be a welcome development to consumers  from much of the dangers of the current banking system, while providing banks with unleveraged, low risk fee income which would free bank shareholders and employees from the dangers of leveraged balance sheets. In such a model, banks would come to resemble asset management firms with multitudinous branches, high touch, in-person customer service, vaults, wire transfer operations, and mortgage funds.

We need reform now. The current banking system has spawned a variety of patchwork government fixes which do not address the underlying issues of structural stability and soundness. Government intervention is a band aid on a banking system which is hemorrhaging capital and needs an aggressive, evolutionary change in structure.

Most importantly, an unleveraged system which matches the durations of assets and liabilities would dampen financial cycles by not removing capital from the system precisely when it is under the most stress and needs investment funds. Capital would be constantly available and controlled through the markets, not highly-leveraged financial institutions, central banks, politically motivated legislators, or government interventions, which only worsen financial cycles.

Comments

[apppro:]

I know this isn't very PC right now, but here's a thought: maybe if we stopped forcing the banks to 'mark to market' a load of securities that short sellers have convinced everyone are worthless, then maybe there wouldn't be such a crisis.
THEN, how about we institute a "WINDFALL PROFITS TAX" on those shorts who have outlandishly profited from the destruction of our banks, insurers, mortgage companies, and economy at large.

Oh yeah I know the arguement the shorts give:

"No..no..no! It ain't me babe! I ain't me you're looking for, babe!"

2008 Jul 16 08:01 AM

[Chris White:]

Why do we have one? What is the financial system for? How well is it meeting its purposes? What should it be doing?

2008 Jul 16 09:28 AM

[DougM:]

"Mortgages are long term in nature, while deposits (other than CDs) can be pulled at a moment's notice. Why would we allow a system where short-term liabilities are systematically allowed to fund long-term holdings of investment assets?"

Some sort of mechanism for doing this is necessary to couple savers with borrowers. Savers need some sort of return to offset inflation, but typically can't take the interest-rate risk of buying 30-year instruments. Many savers use CDs, but these too are typically no longer than 5-year instruments. Banks bear this risk in exchange for capturing the spread between the long and short end of the curve. Credit risk is admittedly an extra level of risk, however it's hard to see how a corporate bond is that much less risky than a portfolio of high-quality mortgages. Indeed, the credit quality of most corporations is so poor now that banks might have trouble finding enough AAA-rated corporates to implement the scheme you've proposed, and the yields are so poor on AAA-rated governments that it's hard to see how the banks could offer any kind of return to savers after taking their spread. The current system works well provided people holding the short end (the savers) don't lose confidence in it. It works because it averages the inflows and outflows from a large number of people against the long-term loans. In the end, it's all about confidence. FDR figured this out back in the 30s, and put in place most of the structure we have now. Financial institutions have gotten increasingly creative about circumventing this structure, and regulators who are supposed to ensure that banks don't behave recklessly have been asleep at the switch. This is nothing that we can't fix with better and more diligent regulation IMO.

2008 Jul 16 12:46 PM

[truthABC:]

I absolutely agree we have to get rid of fractional reserve banking. The Federal Reserve, a private bank owned by a cabal of elite banking families, has a strangle hold on the economy through the fractional reserve system. To put it simply, they can loan out money that doesn't exist. The only end result of paper money that can be created out of thin air by the Feb and charged back to us at interest is DEBT. It is impossible to pay back the loans because there would never be enough money in circulation. Its a vicious circle. To stimulate the economy, the Feb creates more money out of thin air, but this has the consequence of making the money in circulation have less value (inflation). Their solution to bring down inflation by stimulating the economy? Print more money! The end result is control of our economy and society because we cant escape the debt we owe to the banking cartel. WAKE UP PEOPLE. It is ILLEGAL according to the CONSITUTION to let a private bank regulate our money supply. So why do we stand for it? Because we don't know any better. We are told by "experts" that we need the Feb. ITS A SCAM. As simple as that. Google or YouTube out Ron Paul. He can explain it much better than me!

2008 Jul 16 01:45 PM