A Radical Solution for America's Insolvent Financial System

by: Mansoor H. Khan

A plan for the resolution of the insolvency of the U.S. banking system:

The core problem of the U.S. banking system (and maybe the world's banking system) is not liquidity but insolvency. The liabilities of the U.S. banking system exceed the value of its assets. The issue is not only the toxic assets (toxic mortgage backed securities, toxic commercial real estate loans, sub-prime mortgages, alt-A loans, adjustable loans likely to go bust, increase in prime mortgage default rates, etc) but also off-balance sheet liabilities (such as expected, huge-unaccounted-for future derivatives losses).

This means that bailouts are just beginning and will require bigger and bigger sums of taxpayer money as time goes on. The government will resort to borrowing more and more and eventually to printing money when treasury debt auctions start failing. The end result of this path is a currency collapse and probably total chaos as expected by gold bugs.

One other way to deal with this issue is to stop the bailouts and let the dominoes fall. Defaults and cross-defaults will cause many, many depository institutions (even very large ones) to collapse, leading to an extreme decrease in money supply as bank deposits are destroyed. Deposits of failed banks cannot be used to pay bills, make purchases and/or service debts.

Which will probably lead to even more defaults as unemployment increases and debtor's are unable to service their debts. This process will probably cause extreme deflation as businesses lower prices in a bid to survive. This will also lead to wage cuts, increased unemployment and a deflation spiral and much chaos. But probably less chaos than a currency collapse.

Is there a better way?

Here is my idea:

1) We essentially need an orderly bankruptcy and liquidation of the U.S. financial system.

2) I suggest we create a government owned bank and transfer all deposits of the private commercial banking system to the new government owned bank. This "transfer" is really just new money creation. This new money will be digital cash (electronic version of physical paper cash). Very much like reserves at the Fed.

3) Note that the plan will not create net new money since we will be destroying all deposits of the commercial banking system in the process.

4) All assets of the commercial banking system will be transferred to the government and auctioned off in an orderly manner over the next 10 years. The proceeds from the sale would go the United States treasury and not the commercial banks. The assumption here is that commercial banks deserve nothing since the entire industry would have been most likely destroyed any way. Even good banks would have been destroyed due to bank runs and defaults if the government had allowed the dominoes to fall. Of course bank shareholders, bank bond holders and counter parties of bank derivatives would not receive anything.

5) After the transfer FDIC protection will be removed for any private bank which wishes to remain in business or any new private depository institution or bank. From that point on the government should make it absolutely clear that there will be no more bailouts and no more conversions. This will discourage (but not completely eliminate) fractional reserve deposit banking and private money creation that results from pyramiding of government created money. This will also limit debasement of the currency that results from fractional reserve deposit banking. In fact, we can have "free banking" from that point on and not even have reserve requirements or capital requirements. All depositors who use private banks will be fully at-risk. The industry will have to set the interest rate high enough to attract depositors.

6) The new government bank will act as an electronic "piggy bank" only. All deposits will be 100% reserve and it will make no loans. Loan making will be left to the private banking system (with no deposit insurance or a possibility of a future bailout). The new government-owned bank exists only as a "safe" money storage and a payment clearing system so the public does not have to carry around physical paper cash to make purchases and pay bills.

6) Of course this plan is not without pain or cost. Cost of funds for banks and borrowers will probably rise as bank deposits are a source of very low cost money for the banks. Nothing is free. We are just exchanging higher cost of funds for removal of systemic failure risk. Economically we are recognizing that when money is loaned there is always credit risk.

7) We are just separating the payment and clearing transaction system which is absolutely necessary for day-to-day commerce (no credit risk) from the loan banking and investment system (has credit risk).

About this article:

Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here