Thursday, May 14, 2009

The Classical Banking Club : Further Suggestions.

Laurence J. Kotlikoff (Boston University) and John C. Goodman (National Center for Policy Analysis) join the club with their proposal of “Limited Purpose Banking”.

In a paper published in The New Republic (“Back to Basics”, May 14), and signaled by Greg Mankiw on his blog, they suggest a radical reform of the way banks do business.

The disease, they write, is letting financial companies borrow in order to gamble with depositors’ money by buying various financial assets that could put them and their customers in a highly risked position, while the depositors expected a secure one. Under their proposed “Limited Purpose Banking” all financial corporations, including banks and insurance companies, would function exclusively as middlemen. They would never, themselves, own financial assets or borrow to invest in securities but would be permitted to one and only one set of activities: create safe as well as risky collections of securities (mutual funds), sell shares to these funds to the public, and use the proceeds to purchase assets for the funds.

The funds would be specialized, for instance in mortgages, or commercial paper, or cash management, and so on and would thus be perfectly transparent, under the control of the financial authorities, and provide finance to the economy. Checking account money would be placed exclusively in cash mutual funds and thus would comply with a one-hundred-percent reserve requirement, as was advocated by leading economists such as Henry Simons, Irving Fisher or Frank Knight in the 1930s.

Under this scheme, banks would let buyers of the funds gamble if they want, but not gamble themselves. They would never be in a position to fail because of ill-advised financial bets and would not need massive capital reserves as guarantee against possible runs.

There is a drawback, however, to this proposal: “Bankers will likely fight this reform tooth and nail”.

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