Is Traditional Banking History?

Traditional banking is unsafe at any speed. The Great Financial Crisis was proof positive. Yet our politicians rebuilt the system to die another day. That day is here. The financial earth is moving beneath our feet. Silicon Valley and Signature banks just went poof — the second and third largest U.S. bank failures ever. Days later, Credit Suisse, a global bank and Switzerland’s second largest, went poof — sold to UBS for peanuts – this despite $54 billion in mouth to mouth from the Swiss central bank. First Republic, our 18^th largest bank, lies at death’s door. Yes, it was “rescued” with a $30 billion deposit by JP Morgan and ten other mega banks. But making deposits, rather than buying stock, was a kiss of death, instantly producing a junk credit ranking. Republic’s share price is down 90 percent from a year back.

Every financial panic is different, but leverage and opacity are the common denominators. The 2007-2008 Global Financial Crisis (GFC) featured banks running on investment banks, shadow banks, and insurance companies. The current crisis is the stuff of the Thirties – people running on banks. But they are running with their fingers — tweeting RUN! as they type wire instructions.

Deposits represent borrowed money — leverage. Dodd-Frank, the post-Great Financial Crisis (GFC) legislation limited leverage. But not by much. Most banks are permitted 90 cents of debt for every dollar of assets. Thus, if their assets drop 10 percent, it’s lights out. Unfortunately, as Treasury Secretary Yellen just testified, you can’t be a little bit leveraged.

If a bank has an overwhelming run that’s spurred by social media or whatever, … (it) can be put in danger of failing.

The “whatever” is opacity — not knowing if your trusted depository has your money. The GFC’s opacity involved specious subprime mortgages. The opacity underlying today’s crisis is valuing bank assets at their book, not their far lower market value. Who sanctioned this practice? The Financial Accounting Standards Board.

Cooking the books with the accounting profession’s blessing has, according to economists, left 2,315 of our 4,236 FDIC-insured commercial banks insolvent! Hence, we have, today, the basis for a run to beat all runs. Yes, the Three Musketeers — the Treasury, the FDIC, and the Fed — could try to avoid this outcome by insuring all deposits. They’re terrified to do so. There are $8 trillion in uninsured deposits that could be pulled despite the assurance of insurance. Since last April, the banking system’s has lost $1 trillion of its $18 trillion in deposits, much fleeing since SVB’s
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collapse.

A continued run or even trot of uninsured deposits to safety spells more bank failures landing in the FDIC’s lap. But the FDIC had a measly $128 billion at the end of December. Thus more runs means an FDIC bailout by the Fed, which means more money printing, which means greater inflation fears, which means more people, including insured depositors, withdrawing their money to buy something real. Or it could force banks to start paying high rates to retain deposits. In this case, they’ll go broke gradually in a reprieve of the S&L crisis. Yes, today’s 2,315 insolvent banks can luck out on the market. But time, per se, is not their friend.

Much of the money exiting banks is moving to 100 percent equity-financed mutual funds. This represents an endogenous switch to Limited Purpose Banking (LPB) — the all-equity, mutual-fund financial system one of us (Kotlikoff) advocated, starting in 2008. LPB limits financial middlemen to their legitimate purpose — intermediation, not gambling with other people’s money. Households and business can and must take risks. But no one should play dice with a major public good — the financial exchange system.

LPB was tested during the GFC. Then, as now, there were over 7,000 equity-financed mutual funds. None failed. Yes, money-market funds needed rescue. But they were leveraged. That’s no longer the case. LPB is old hat. Most Americans do more LPB banking than traditional banking via retirement accounts.

Still, LPB is only partially in place. In particular, we need cash mutual funds that hold just cash. Such funds would charge a fee for their storage service and effecting electronic payments, including debit cards and bill pay. Cash mutual funds provide the Narrow Banking championed in the 1930s by Irving Fisher, Frank Knight, and other economists.

LPB goes far beyond Narrow Banking. Current equity-financed mutual funds invest in everything under the sun, including stocks, bonds, real estate trusts, mortgages, and small business loans. Investment in illiquid assets, like mortgages, small business loans, and personal loans, including credit card lines of credit, arise through closed end funds. Unlike open end funds, closed end funds have no redemption requirement. They pay shareholders as investment income accrues. As for risk pooling, LPB uses contingent mutual funds to provide insurance, a practice that dates back centuries to Tontines and parimutuel betting.

LPB also ends opacity. It establishes the Financial Services Authority to verify and disclose, in real time, all assets held by all mutual funds. This disclosure would make the secondary market in closed end funds highly liquid.

You can be sure that bankers and regulators will claim This time was different. Now, we’ll get the regulation right. Fortunately, this time is different. The global economy has too much at stake to maintain a banking system that’s built to fail. Traditional banking has caused economic havoc for centuries. Its days are numbered in keystrokes. Policymakers need to recognize this reality and organize an orderly transition to Limited Purpose Banking.

This article was co-authored with Theo Kocken, an economist at Vrije Universiteit Amsterdam.