The Case for Radical Banking Reform

Originally published by the Carnegie Endowment for International Peace
Participants: Laurence Kotlikoff, Douglas Elliott, Uri Dadush

The recent banking crisis laid bare the weaknesses of the current system, and few would disagree that reform is needed. As debate rages in the U.S. Congress and European parliaments, however, agreement on how to reform the system remains elusive.

Laurence Kotlikoff, William Fairfield Warren Professor of Economics at Boston University, advocated one solution: limited purpose banking. Brookings fellow Douglas Elliott discussed Kotlikoff’s proposal and Carnegie’s Uri Dadush moderated.

The Nature of Limited Purpose Banking

Kotlikoff argued that the United States has already seen the “impossible” happen: during the financial crisis, credit markets nearly collapsed and stalwarts of the American economy, including AIG, GM, and Citigroup, had to be rescued by the government.

If, in another “impossible” scenario, a loss of confidence in the U.S. dollar were to spark a run on banks, the FDIC would be responsible for $6 trillion dollars worth of bank deposits, despite having only $18 billion in reserves. To maintain its guarantee, the federal government would have to print trillions of dollars, leading to hyperinflation, skyrocketing interest rates, and a collapse in economic output.

In other words, under the current banking system, the federal government is insuring the uninsurable. If markets lose confidence in the U.S. government’s ability to pay—just as happened to AIG during the crisis—the financial system could come to another, and more severe, crashing halt.

To ensure that this does not happen, Kotlikoff proposed a limited purpose banking (LPB).

• Under this system, any limited liability financial firm would have to operate as a mutual fund—in effect, a bank with a capital requirement of 100 percent. These firms would act solely as financial intermediaries, connecting savers to investors.
• Mutual funds already make up one third of today’s financial system and they held up remarkably well during the crisis. Expanding this system, Kotlikoff argued, is much wiser than rebuilding on the one that collapsed.
• Investors, and not banks, would take on risk. Though mutual funds could still invest in any financial instrument, regardless of risk or complexity, they would do so only on investors’ behalf and in a fully transparent manner.
• Since the mutual funds could not hold any investments of their own, the system would be immune to widespread contagion.

Limited purpose banking would also extend to the insurance industry.

• Currently, insurance firms guarantee fixed payoffs and are expected to cover aggregate risk: if, for example, a deadly epidemic were to break out, the life insurance industry would be liable for billions of dollars in payouts, likely rendering them insolvent.
• Under Kotlikoff’s proposed payout system, however, individuals would enter into an insurance pool and, when they had a claim to payouts, would receive a share of the pool—rather than a fixed amount—preventing the insurance industry from ever having liabilities it could not pay.

Limited Purpose Banks (LPBs) would require only one regulatory agency, the Federal Financial Authority (FFA).  The FFA would be tasked with verifying the financial statements of the securities bought and sold by LPBs, hiring independent rating agencies to appraise the value of these securities, and disclosing this information to the public.

The Impact of Limited Purpose Banking

Such sweeping reform would undoubtedly have a profound impact on the financial system, and Elliott noted several issues of particular concern.

• Financial Bubbles: Though Elliott conceded that LPBs would largely resolve moral hazard and contagion issues, he maintained that LPBs would still be vulnerable to bubbles like those that formed in the real estate markets before the crisis. Kotlikoff agreed, but argued that such bubbles would not threaten the entire financial system as they do today.
• Regulation: Additionally, Elliott feared that giving such far-reaching power to the FFA would increase the likelihood of regulatory mismanagement, like that which preceded the crisis. He suggested that simplifying financial instruments could reduce regulatory problems, but noted that this would be equally possible under the present system.
• Lost Efficiency: Elliott argued that the cost in terms of foregone efficiency would be too high to justify such a system. One of the key functions of banks is to transform assets from the safe, highly liquid kind that most people want into the ones that promote growth—typically long-term, illiquid investments. LPB would render them unable to do this. The advantages of a safer financial system should be balanced against the efficiency advantages of this “maturity transformation.” Kotlikoff responded by noting that the same effect could be achieved by holding a mix of long and short term assets.
• Credit to Businesses:  Elliott claimed that business credit would become scarcer and more expensive. Many businesses rely on contingent commitments—guarantees of lines of credit that can be borrowed from as need arises—and these would be difficult, if not impossible, to have with LPBs. Kotlikoff argued that while LPB would limit the money supply, the amount of real credit—credit backed by assets—available would not change.
• The Insurance Industry: According to Elliott, providing individuals with a known payoff has real value, and LPB would not allow insurance firms to do so.  Additionally, Kotlikoff’s proposal could create adverse selection issues and would be very difficult to implement.
• The Impact on Growth: Kotlikoff claimed that while an economy with only LPBs may grow slightly slower than the current one, it would avoid major financial crises that cause sharp, painful recessions.   However, Elliott noted that the occasional major loss may not necessarily be worse than a consistently slower growth rate.
• Implementing LPB: Finally, Elliott argued that the transition to limited purpose banking would be turbulent, and could cause dangerous fluctuations in credit availability. The effects of economic policy, such as interest rate adjustments, could change significantly, requiring policy makers to engage in some trial-and-error before sound policy could be achieved.