Limited Purpose Banking

Description

By Christophe Chamley and Laurence J. Kotlikoff:

"If you want markets to function, don’t let critical market makers -those who connect suppliers and demanders (e.g., refineries and motorists) of essential products - gamble with their businesses.

Apply the moral to banks and the regulatory prescription is clear. Don’t let banks take risky positions. Make banks stick to their two critical functions - mediating the payments system and connecting lenders to borrowers.

To safeguard the payment system, banks must hold 100 per cent reserves against their deposits either in cash or short-term US treasuries. With 100 per cent reserves, banks runs will be history.

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Banks should be allowed to initiate only conforming, i.e., government-approved, AAA-rated mortgages and business loans. These would be long-term, fixed-rate loans with 20 per cent-down and payments below 25 per cent of income. The government, via the Federal Financial Authority, would use tax records to verify loan payment-to-income ratios. It would also spot check collateral. Once approved, the banks would bundle and sell “their” loans within mutual funds.

Again, traditional bank runs wouldn’t arise. And today’s bank runs, which entail lenders and equity investors avoiding risky banks, wouldn’t either. Why? Because banks would bear zero risk. Mutual fund owners would bear risk, but not the banks. And these lenders would know they were buying government-approved AAA-rated loans, not Bear Stearns‘ CDOs.

This limited purpose banking is a modern version of narrow banking proposed by Frank Knight, Henry Simons, and Irving Fisher. Banks would hold deposits, cash checks, wire money, originate loans, and market mutual funds, including money market funds with no guarantee of par value redemption.

With limited purpose banking, financial crises would largely disappear. Banks would never fail, never stop originating loans, never expose the public to massive liabilities, and never see their stock values evaporate. Banks would be stable, boring economic cogs - like gas stations. The Fed would also gain full control of the money supply. To expand the money supply, the Fed would continue buying treasuries from the public and supplying cash. But banks wouldn’t be multiplying and contracting M1 (cash plus demand deposits) based on their ever changing decisions about lending deposited funds.

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What about investment banks, brokerage firms, hedge funds, and insurance companies? What’s their right financial order?

Again, regulate to purpose. Investment banks take companies public and assist in mergers and acquisitions. They shouldn’t be permitted to invest in their clients’ companies. Brokerage firms are here to help us buy and sell assets, not to gamble on spreads. Hedge funds are here to help limit risk exposure. They aren’t here to insure these risks themselves. Finally, insurance companies are here to diversify risk, not write insurance against aggregate shocks. The FFA and “less is more” limited purpose banking won’t prevent asset markets from occasionally going nuts. But the functioning of financial markets will no longer be in question. Nor will con artists, parading as “financial engineers,” ever again be free to wreak havoc on the nation’s finances and its citizenry." (http://people.bu.edu/kotlikof/newweb/LimitedPurposeBanking1-27-09.pdf)