For the good of the coun­try, I sug­gest that we lawyers go first. Mr. Field, please bring up the abo­li­tion of LLPs at your next county bar asso­ci­a­tion meet­ing, and get back to us when you have their endorsement.

Lawyers can’t limit their malpractice liability by using a corporate or other format. They remain personally liable regardless.

In case you hadn’t noticed, this is what banks are already doing for the vast majority of their retail customers.

Allan Walstad: I don’t buy that, Pen­der. Let invest­ment firms fail. The phys­i­cal cap­i­tal still exists and gets bought up at a frac­tion of book value by other investors. Life goes on.

No, it gets sold off at a fraction of book value to pay off the firm’s creditors. Those creditors will have taken severe losses while potential creditors will only lend out money when it’s close to a sure bet. You don’t need actual destruction of physical capital to have a pretty serious recession or depression.

I like the idea of mandating all proprietary trading to be undertaken by partnerships. By itself, it’s definitely not a solution, though. Long Term Capital Management and most other hedge funds are structured as partnerships, for instance. I would note the key individual who helped push Goldman Sachs toward an IPO was former chairman and partner Jon Corzine. As a bond trader, his main motivation was to establish a permanent base of capital for the firm so that it could expand its prop trading.

Split the banks from the casinos and you haven’t solved anything, because you can’t let either one fail.

I don’t buy that, Pender. Let investment firms fail. The physical capital still exists and gets bought up at a fraction of book value by other investors. Life goes on.

No credit = caveman economy.

Not quite. People can save. When you’ve saved up enough, you can buy something, whether consumer goods or capital goods. Yes, a functioning credit system is useful but it’s not the whole difference between us and the stone age. And as for who gets trusted with capital, I tell you what: you worry about your capital and I’ll worry about mine.

Securities are investment. Investment is about deciding who should be trusted with capital. Capital allocation decisions are about which actors bigger than an individual home-buyer gets credit. No credit = caveman economy. The casinos make that happen. Split the banks from the casinos and you haven’t solved anything, because you can’t let either one fail.

Mark Field: I have a very simple suggestion: require that all financial institutions drop their corporate status and do business only as partnerships. When the senior partners have their own, uh, assets on the line, I’m confident they will approach risk in a wholly different way.

Yes. They’ll make VERY sure that they are in the good graces of politicians who have the power to save their business (and therefore their own assets) using the public purse.

How is that an improvement?

The financial crisis wasn’t caused by the absence of fully regulated, risk-free investments. The crisis was the result of many decades of “risk creep”.

First, somebody offers an investment that’s almost risk-free, and offers a better return than risk-free investments. Over time, its safety is confirmed again and again, and investors looking for risk-free investments begin to drift towards it, attracted by the greater return. Eventually, everybody thinks of the almost-risk-free investment as “risk-free, for all practical purposes”, and treats it that way. Then someone offers a new investment that’s almost as risk-free…lather, rinse, repeat.

The solution to this problem? We’ve just experienced it. The occasional crisis is necessary to help investors reset their expectations of investment risk. Rather than prevent them, we need to make sure that they happen more regularly, because the more frequent they are, the less catastrophic they’re going to be.

ARCraig says:
Oddly enough, of all people Ron Paul makes a similar argument in End the Fed. Of course, he doesn’t want the government to mandate a distinction, rather he sees the conflation of the “warehousing” and “investment” functions of banks as being a result of fractional reserve banking, which he sees as fundamentally fraudulent. In his ideal free banking, full-reserve world, savings accounts would not have to be invested because inflation wouldn’t cause them to lose value if they were simply saved.

Perhaps the distinction could be secured by tinkering with the legal definition of “bank.” A “bank” or perhaps “savings bank” would be defined as an institution that simply warehouses money and pays out checks, for a fee. An institution that engages in lending or investments might be termed an “investment institution” or “investment pool.” I suppose you could also set up a holding company for a combination of institutions under one roof, such that if the investment arm goes bust the money in the savings arm stays with the depositors.

People expect that when they put money in a bank it will be there for them whenever they want it, no matter what. They would not have the same expectation if the name of the institution reflected the fact that almost all their money was going into some sort of investment pool. Like, if you get together with several buddies and each kick in $10,000 to invest or lend out, you know darn well the money isn’t just sitting there waiting for you, and you know there’s risk of large losses. People think a bank is different, but in essence it really isn’t (aside from the fact that banks as they exist now are actually agents of a central inflation machine that generates bubbles, the bursting of which is blamed on the market instead of the Fed–and, if they go bust the taxpayers are on the hook).

The idea here is that this definitional move would not be part of any comprehensive regulatory scheme but would simply clarify the nature of the institutions in which people might put their money. You could still set up any sort of financial company you want, but if it’s lending or investing you couldn’t call it a “bank.” Just an idea for possible discussion.

Edward Herman told us what would happen, and he was right.

Joe Sixpack thought he was putting a little by in a safe bank, but he didn’t realize that Wall Street had turned all banks into risk banks.

In the pre- and post-GS era, we had panics every 7 years and never more than 20 years apart. During the G-S era, none in 60 years.

It’s hard to argue with a record like that.

ARCraig: Oddly enough, of all people Ron Paul makes a similar argument in End the Fed. Of course, he doesn’t want the government to mandate a distinction, rather he sees the conflation of the “warehousing” and “investment” functions of banks as being a result of fractional reserve banking, which he sees as fundamentally fraudulent. In his ideal free banking, full-reserve world, savings accounts would not have to be invested because inflation wouldn’t cause them to lose value if they were simply saved.

That presidential pamphleteer has been arguing about removing the fed and going back to gold for ever and ever, amen. He is a stopped clock that is right once every 30 years.

People have lots of trade credit relationships, so there is a dense web of modestly analyzed relationships that impact when trade credit (for example a 30 day net sale, a bank deposit, interbank loans, check float from an institution that writes lots of checks, etc.) that impacts the whole economy goes bad. Large numbers of people act fearfully in crashes because large numbers of people really do have a lot of risk, even if the fear itself is a big part of the problem. Bankruptcies like the Bear Sterns bankruptcy didn’t harm the economy much, because operating businesses could be swiftly spun off in tact.

I also disagree that the definitional problem has to be that hard. There are a theoretically infinite number of possible transactions, but a quite small number of types of transactions (common stock, corporate bonds, residential mortgages, consumer car loans, credit card loans, SBA loans, commercial mortgages, working capital loans to businesses (with or without security)), that make up a very large part of the entire capital market. Most of these deals are on the right side of the fence already. A small percentage, like credit default swaps should have insurance style regulation rather than investment banking style regulation.

The risky side of the business ought to be regulated through institutional arrangements. Who bears the downside risk and whether the incentives are aligned matters much more with risky investments than it does with boring ones.

Debt-equity bias control also has the potential to be very fruitful.

The promise of Keynsian economics was that the Fed could control hot and cold levers to control inflation and keep unemployment low. Experience has shown the truly ending the business cycles and bubbles is essentially impossible. But, while we can’t end business cycles and bubbles, we can make their consequences much less great by building a more robust economy with less leverage. The policy tools needed to make a recession survivable are closer to our grasp than the ones needed to prevent recessions.

Pre-FDIC banks routinely had 50%+ failure rates over ten to fifteen year periods. Now, even at the bottom of the Great Recession and in the later parts of the Great Depression, they weren’t more than a few percent, even with really pretty modest capital cushions. A pretty small reduction in debt levels can have a big impact on economic harm.

I recognize that this is only an ideal and that as with all of these flawed proposals the devil is in the details, but I believe an approach along these lines is likely to be better than the others which even in their idealized forms would not address the key issue– costs of distress in the form of uncertainty.

require that all financial institutions drop their corporate status and do business only as partnerships.

For the good of the country, I suggest that we lawyers go first. Mr. Field, please bring up the abolition of LLPs at your next county bar association meeting, and get back to us when you have their endorsement.

This is not to argue that there is no way of making finance safe. There is. But it would be far more radical: deposits would be 100 per cent reserve backed; and the liabilities of other investment vehicles would be adjusted for the market value of their assets at all times. Banking would disappear.

This mirrors a debate a co-worker and I had recently (we work for a large, global bank). What we think would actually happen is that lending would disappear. The fractional reserve system is the main source of funds available for lending; take that away, and banks can’t do much more than toss cash into a vault**.

But there is still extraordinarily strong demand for deposit services, both consumer and commercial; so banking would still exist, but instead of making their profits via fractional lending… it would all be made by charging fees for deposits.

No more free checking, no more competition on deposit interest rates, no more free-to-use ATMs. If you turn deposits into a 100% on-hand system, then every dollar a bank holds for you costs them money; every new account is a marginal cost… and that cost gets passed to the consumer. And in some cases–small business banking, consumer banking under $10,000–those fees would be high enough to make banking uneconomical.

But here’s the thing–the tipping point to make banks go fee-based instead of fractional is not at the radical 100% reserve point Wolf posits. It is much closer than 100%; I won’t speculate where between 10% and 100% it lies, since that depends on individual institutions. But the simple truth is, the instant you increase the reserve requirement, you cut off lending availability along with bank profits, and force them closer to that point where fees become the primary profit driver.

—————————————
**Banks could still get away with lending on time-based assets, such as CDs or bonds, depending on how many loopholes the anti-fractional reserve legislation had. But given those assets’ hard maturity date and coupon costs, the bank’s rate of return on that lending would have to be very high in order to justify doing business that way. In short, they would have to pay out very low interest to consumers, and charge very high interest for loans.

It occurs to me that the real problem here is the lemming-like behavior of the whole of the financial sector. Someone figures out a way to make money a certain way and everyone else lines up marching to the same beat. When the leader(s) inadvetently jump off a cliff the rest of the pack follows.

-Riskable
“Those who choose proprietary software will pay for their decision.”a

Cheers,

Regulators could also require that, in order to sell a security, the seller would have to file a statement explaining how to value the security and its component parts. Any material inaccuracy in the explanation of valuation could trigger Rule 10b-5 or equivalent liability.

If you actually look at the financial meltdown, it could be argued that failure happened when institutions tried to limit their risk but maximize profit. The so called doubling and tripling down on what they believed to be safe bets.

The analogy could be summed up that the banks and bankers thought they had rigged the race, and then looked at every single possible way (parlays and what not) to place a bet on the outcome. They then paid themselves based on profits they told their shareholders were going to come from the bets placed. Well the horse broke a leg rounding the final turn, and well, S&%*t happens (there is never a sure thing). Using this analogy imagine how your own betting would be different if you didn’t “know” a race was fixed vs. you “know” it is.

So as I see it the problems occur when there is the appearance of no-risk. So the solution is to create a system that eliminates or reduces the ways to reduce risk. This would align the economic system with core capital beliefs that higher risks yield higher rewards. That is not the current way things are happening. Currently the most money is being made by finding the appearance of little or no risk and placing as much money behind that bet as possible. That is how JP and GS made their money this quarter. Lending right now is risky (so they dont do it) trading safe treasury bonds and other stuff is (so they are doing it).

While the perception is that bankers are risk takers, they aren’t. They want sure things. Nobody wants to inject more risk into the system, all the people looking to solve the problem are bankers and lawyers…and all have been looking to find the least risky bets for years.

Why would lending to households and business be good, but securitising those loans bad?

I think the argument is that securitization diffuses the risk and removes the incentive for the originator to perform adequate due diligence. That’s still a lousy objection, since Glass-Steagall wouldn’t prohibit the securitization process (the argument seems to have a bit of the “underpants gnome” structure: glass-steagall > ? > less risk!)