Fixing Wall Street for Real

Fixing Wall Street for Real

Thanks to rampant fraud, regulatory failure, corporate greed, political kickbacks, insider-ratings and policy failures, our financial system collapsed in 2008, putting 8.5 million Americans out of work and wiping out trillions in retirement savings. Unfortunately, the Dodd-Frank banking legislation did nothing to address the two core problems precipitating the banking crisis: leverage and opacity. Consequently, the financial system is poised to re-detonate.

Traditional banking is unsafe at any speed. Even a very low, 10 to 1 leverage ratio (meaning the bank has borrowed $9 of every $10 it holds in assets) can lead to a bank run. The reason is simple. If the value of the bank’s assets falls by just 10 percent, its liabilities will exceed its assets. If enough of the banks creditors believe the bank is broke or may be broke because others think it may be broke, they will run to retrieve their money before other creditors take all the money that’s left. The run will guarantee the bank is either bailed out, bought out or forced to declare bankruptcy.

The fragility of traditional banking is dramatically worsened by opacity – the failure of banks to disclose the precise nature of their assets. If you and other creditors/lenders to a bank can’t tell what the bank is doing with your money, the slightest piece of bad news about the bank’s assets can spark a run. The run can instantly spread to other banks as creditors of those banks question whether they can really trust that their own banks have the money they’ve promised to repay them and, if not, whether other creditors will withdraw all the money that’s left. Panic, whether well founded or not, can quickly undermine our trust-me banking system. It can do so today even more quickly as happened in 2008 when Lehman Brothers collapsed because Dodd-Frank has reduced the likelihood that Uncle Sam will arrive in the nick of time to make creditors whole.

The specter of bank failure is a signal to non-financial companies that money will be tight and that other companies will be laying off their workers as a result. But one company’s workers are another company’s customers. Hence, bank runs trigger firing runs in which companies fire their workers because they think other companies are or will shortly be firing their customers. Thus the massive economic collapse of 2008 was triggered as much by collective panic as anything else. Yes, major banks were and had failed, but the Fed was stepping up to provide loans to all comers, including RV dealerships and other companies to which the Fed had never made loans. Still, if you have to make payroll and you’re no longer sure your customers will have jobs, you don’t take chances. You lay off your workers before you, yourself, go under. In the months immediately following Lehman Brothers’ collapse, roughly a half a million workers on Main Street were tossed out on the street every month because the banking panic had lead to an economic panic.

If the banks were selling hot dogs, no one would care if people fled the market for weiners because of a rumor, whether true or not, that they contained E. coli. If the market collapsed and there were no more hot dogs, we could easily live without hot dogs, for years, if necessary. But the banks aren’t selling hot dogs. What they are doing is running a public good, namely the financial highway system. We wouldn’t let one of the primary participants in our regular highway system, namely gas stations, collectively gamble with their businesses and periodically fail (simultaneously) leaving us unable to drive or transport goods. No. Congress would immediately pass a law making it a criminal offense for gas station owners to gamble with their businesses.

In the case of Wall Street, there is no such law. Why not? It’s simple. The banks, particularly the handful of very big banks, have bribed Congress (not with cash in brown paper bags, but with campaign contributions) to let them borrow money, keep their creditors in the dark about how the money is invested, pocket the winnings and leave taxpayers to cover their losses. Heads I win, tails you lose is working for the banks. It’s not working for us.

It’s time to end trust-me banking. It’s time to fix the financial system from scratch. My proposed reform, called Limited Purpose Banking, does that. It eliminates leverage by banks and all other financial intermediaries, and it forces all financial intermediaries to disclose online, in real time and in fine detail their assets and liabilities.

The plan is remarkably simple. As you can see at, Limited Purpose Banking has been formally endorsed or strongly supported by prominent economists and policymakers. The list includes five Nobel Laureates in economics; Mervyn King, former Bank of England Governor; George Shultz, a veteran of two U.S. administrations; Robert Reich, who served as secretary of Labor; and former U.S. Senator Bill Bradley, the Stephen Curry of his day.

In my 2010 book, Jimmy Stewart Is Dead, I discussed the 2008 financial crisis from an economist’s perspective and presented my Limited Purpose Banking proposal. I chose my book’s title to point out that we don’t live in Bedford Falls. Nor do we have our close and trusted friend, George Bailey, running the local bank. The Christmas movie that we’ve all seen many times over — It’s a Wonderful Life, depicting George (played by Jimmy Stewart) saving his bank with the words “trust me” — wasn’t playing in 2008 and it’s not playing today.

I sent my plan and later my book to Congressman Barney Frank (of Dodd-Frank), hoping it would influence the Dodd-Frank legislation. I had met Congressman Frank once before and wanted to meet with him before the new banking law was passed. That didn’t happen. But Congressman Frank did ask me to meet with him shortly after the Dodd-Frank bill was passed. When we met, the book was on his desk. He told me he’d read it in full and that a) it was exactly the right answer, b) Dodd-Frank was a “stop gap” measure, and c) he would work in the fall to enact my plan. I was delighted to hear this. But the Democrats lost control of the House, and Congressman Frank lost his chairmanship of the House Financial Services Committee. Whether Congressman Frank recalls our meeting and what he said and whether he still supports my proposal is for him to say. But six years ago he certainly did.

Limited Purpose Banking (A.K.A. The Purple Financial Plan)

The essence of Limited Purpose Banking (LPB) is to limit financial middlemen to their legitimate purpose, namely intermediating (connecting lenders to borrowers and savers with investors) rather than gambling. The way to arrange this is very simple. You just make all the financial intermediaries operate as 100 percent equity-financed mutual funds.

Most of us are very familiar with equity-financed mutual funds since we have our 401(k)s or other retirement accounts invested in shares (equity) of mutual funds. The mutual funds accept our contributions, give us back shares to their funds and then invest the money in the assets in which they specialized. If the assets they buy perform well, our mutual fund shares go up in value. If they perform poorly, our shares lose value. But regardless of what happens to the value of our mutual fund assets, the mutual fund itself stays in business. It never goes out of business. And, indeed, not a single equity-financed mutual fun failed in the crash of 2008.

Today there are more mutual funds, some 10,000, than there are banks. Thanks to a recent Securities and Exchange Commission ruling that largely forces money market funds to stop falsely claiming they can back your investment to the buck (i.e., you can’t lose what you invested), almost all of these 10,000 mutual funds are 100 percent equity financed and, thus, can never fail. Each of these equity-financed mutual funds can be thought of as a small bank, but one that’s failsafe.

The general idea, then, of Limited Purpose Banking is very simple. It recognizes that equity-financed mutual funds can never fail and requires that all financial intermediaries operate as holding companies (like Fidelity Investments or Vanguard) that issue only 100 percent equity financed mutual funds. This ensures that we never again have a financial run with its attendant economic fallout – never.

In contrast, breaking up the big banks into small banks or restricting commercial banks to invest in particular types of assets – the policies respectively advocated by Senator Sanders and Senator Clinton – provides no guarantee whatsoever against future financial panics. In the Great Depression, one third of the banks failed and virtually all were small.  And the financial collapse of 2008 involved investment banks, mortgage companies, and a huge insurance company, not commercial banks.

There are two types of mutual funds that already exist in the marketplace. Both would be used under LPB. The first is an open-end mutual fund, which invests in liquid assets and permits its shareholders to redeem (cash out) their shares whenever they want. The other type of mutual fund is a closed-end fund, which buys and holds assets.

An example of a closed-end mutual fund is one that invests in mortgages. The mutual fund might buy and hold 30-year mortgages. The shareholders of the mutual fund would collectively receive all the payouts of these mortgages over time and take a hit on those mortgages that defaulted. But the shareholders aren’t locked into this investment. They are free to sell their shares to others on the secondary market.

Closed-end equity-financed mortgage mutual funds that are quite similar to what I just described have been operating in Denmark since 1795. They are also prevalent in Germany and Sweden. They are called covered bonds (the bonds are, effectively, the shares of the mutual fund and they are covered by (or invested in) mortgages.

What happens to checking accounts under LPB? They are replaced by cash mutual funds that literally hold only cash. Their cash holdings would be held on reserve (in safe keeping) with the Federal Reserve. People could write checks on their cash reserve mutual funds. They’d also be able to withdraw their cash holdings at ATM machines. And they’d have debit cards, which they could use to make purchases. The use of the card would electronically transfer funds from the buyer’s cash mutual fund to the seller’s cash mutual fund. They would be no different from today’s debit cards.

In the 1930s, a number of prominent economists from the University of Chicago and Yale University argued that the way to keep the banks from failing again was to make banks invest deposits placed in checking accounts in either cash or highly liquid short-term government securities. This proposal was called Narrow Banking. When they hear about LPB’s cash mutual funds, some people incorrectly conclude that LPB is simply another name for or version of Narrow Banking. That’s absolutely not the case. Yes, LPB’s cash mutual funds represent a way to keep the payment system from ever failing since we’ll always have secure cash holdings to pay for our purchases. But Limited Purpose Banking reforms the entire financial system, not just the payment system. Narrow Banking, for example, permitted banks to borrow to make mortgages and other loans. That’s definitely not the case under LPB. Under LPB, banks become mutual fund holding companies and, if they want to connect lenders to would be mortgagees, they just set up a closed-end equity-financed mutual fund that buys mortgages.

Another key feature of Limited Purpose Banking, which has nothing whatsoever to do with Narrow Banking, is the treatment of the derivatives market. Under LPB, all derivatives are provided via closed-end pari mutuel funds, which operate just like racetrack betting. To get the idea, think about people betting on horses A and B. But let horse A reference IBM defaulting on its bonds over, say, the next six months and horse B reference IBM bonds not defaulting over the next six months. A closed-end mutual fund, which sells shares that pay off if IBM does default as well as shares that pay off if IBM doesn’t default, is, in effect, running a credit default swaps (CDS) market. CDS is a crazy name for an insurance policy, but that’s what it is – insurance against a bond’s defaulting. Someone who wants to be insured against IBM defaulting on its bonds in the next six months would put their money on horse A by buying the shares of the mutual fund that pay off if default occurs. 

AIG, the world’s largest insurance company, went under in 2008 because it sold CDS – guarantees that certain bonds wouldn’t default — and then took the premiums it earned and invested them in a risky manner. That’s very different from AIG simply playing the role of a middleman that organizes betting between those that do and don’t expect a given bond to default over a given period of time. Running such a betting system can never lead to AIG’s failure because all the money is on the table, and it’s the betters’ money, not AIG’s. How do we insure that the money’s actually there and not stolen by AIG? Easy, we require that all LPB closed-end mutual funds hold (custody) their cash and other securities with the Federal Reserve.

Next suppose betting on horse A means betting that GM’s stock, now selling for $200 a share, will rise to $300 a share within three months. Horse B means betting, simply, that it won’t. In this case, the closed-end mutual fund running this bet constitutes an options market since the payoff would depend on whether the stock was above $300 at the end of the three months. Absolutely all derivatives can be run this way, and no mutual fund offering derivatives will every need to be bailed out as did AIG.

Eliminating the Regulators

The politicians have established a vast financial regulator sector to pretend that the banks are being supervised when in reality, in the words of President Franklin D. Roosevelt, they “gamble with other people’s money.” We saw how well all those regulators performed in 2008. Dodd-Frank vastly increases the amount of regulation and number of regulatory bodies. This does nothing to prevent another financial collapse. But it does help two parties – the large banks, since only they can afford the compliance costs, and government bureaucrats.

Under Limited Purpose Banking, there aren’t hundreds of federal and state financial regulatory institutions. There is only one regulator, called the Federal Financial Authority with a very limited mandate, namely to verify and disclose in fine detail and in real time the precise holdings of each and every LPB mutual fund.

Fortunately, the vast majority of bank regulators will find themselves doing what the vast majority of tax attorneys, accountants and IRS staff will be doing — looking for jobs that make a real contribution to society. I don’t mean to be mean or cavalier here about people having to change jobs. I have many friends who work in these professions and have done so honorably for years. But they too recognize that spending one’s life helping people or companies avoid taxes is not socially productive. Neither is calculating tax liabilities and enforcing tax collection when taxes can be vastly simplified and paid with far less personal filing.

Breaking Up the Big Banks

Senator Sanders wants to break up the large banks. But doing so has nothing whatsoever to do with the core problems with trust-me banking — leverage and opacity. In the early 1930s, one-third of the banks failed. The vast majority of them, as measured by their holdings of assets, were small. Hence, having a large number of small banks doing the same things that a small number of big banks do is no guarantee against bank runs and financial crisis. In many ways, breaking up the big banks would make a banking run far more likely, since the government would be letting the creditors to large banks know the government will protect their interests when push comes to shove. This makes them less likely to run to retrieve their money when they hear news about, for example, banks holding liar loans, but have no idea precisely what’s involved.

For her part, Senator Clinton seems willing to break up the big banks once they agree to stop paying her and her husband massive speaking fees to, apparently, tell the banks what they want to hear. I say, apparently, because the senator has yet to disclose the transcripts of her speeches to eight big banks, which collectively paid her close to $2 million for her eight hours of “work.” I view this as a fundamental and flagrant violation of ethics. Public service at the highest levels should not be a ticket to riches from those who seek to influence public decisions. Such service is an incredible honor, and that honor must be sufficient reward.

As for Mr. Trump, he too will become anti-big bank if he determines it will deliver him votes. Mr. Trump, as should by now be clear, has but one cause in which he fervently believes and for which he maintains consistent support – Donald Trump.

If one really thinks the big banks should be broken up into small banks, adopting Limited Purpose Banking is the ideal answer. It forces the big banks to reorganize themselves as mutual fund holding companies that own lots of small banks, namely 100 percent equity-financed and fully disclosed mutual funds.

Transitioning to Limited Purpose Banking

Moving to Limited Purpose Banking is very simple. We simply need to prohibit all borrowing by incorporated financial institutions and mandate that all such institutions reorganize as mutual fund holding companies. Banks will also need to convert their checking accounts to cash mutual funds. There are straightforward ways to do this, and plenty of excess reserves that banks can use to fully back their cash mutual funds, dollar for dollar, with cash. As for their existing loans, banks can continue to manage those assets. But their main task will be establishing and marketing open- and closed-end equity-financed mutual funds.

Summing Up – Eight Steps to Implementing Limited Purpose Banking

Here’s how Limited Purpose Banking (LPB) works in closer detail.

  1. LPB applies to all incorporated financial companies, be they commercial banks, investment banks, insurance companies, hedge funds, credit unions or private equity funds.
  2. All financial corporations (i.e., all financial intermediaries protected by limited liability) must operate exclusively as mutual fund holding companies that market open- or close-end mutual funds.
  3. Mutual funds are not allowed to borrow. Stated differently, they have zero leverage. And, since they are 100 percent equity-financed, no mutual fund can ever fail. Hence, the banking system will never again experience a run and collapse.
  4. Mutual fund holding companies are required to offer cash mutual funds, which hold only cash and are used for the payment system.
  5. Cash mutual funds are naturally backed to the buck. But no other mutual fund, including money market funds, will be permitted to declare they are guaranteeing investment returns.
  6. A single regulator – the Federal Financial Authority (FFA) – hires private companies that work only for it. Their job is to verify, appraise, custody and disclose in precise detail and in real time the assets held by the mutual funds.
  7. Mutual funds buy and sell FFA-processed and disclosed securities at auction. This ensures that issuers of securities, be they households or firms, receive the highest price for their paper (borrow at the lowest rate).
  8. All derivatives are marketed via closed-end mutual funds that operate just like a pari mutuel better at the race track, namely with all money on the table.