Will Limited Purpose Banking Prevent the Next Crisis?

As I have written about the 2008-09 financial crisis (here and here), bailouts appeared to be the only solution at the time. Serious people opposed to bailouts in general, because of their potential to create a moral hazard where there is no dis-incentive to engaging in risky behavior.

Niall Ferguson of Harvard and Laurence Kotlikoff of Boston University write in the December 03 edition of The Financial Times that the solution is reinstating the Glass-Steagall Act and Limited Purpose Banking (LPB). LPB, as stated in the article:

It transforms all financial companies with limited liability, including insurance corporations, into pass-through mutual fund companies. Limited purpose banks would process securities and sell them to mutual funds. They would not be permitted to borrow to invest. Hence, they would never face a run and never fail. Risk-taking would be done by us, the people, via our purchase of more or less risky mutual funds.

They further state this would be done under the watchful eye of a single regulator. From the article:

Under LPB all mutual fund investments would be fully and instantly disclosed on the web by the system's single regulator - the Federal Financial Authority (FFA). The FFA would verify the credit histories, income statements and third-party custody of all fund securities. It would also hire non-conflicted companies to rate the securities and value their collateral. This does not preclude private rating, but it provides the public with independent assessment.

Although the FFA would provide for instant disclosure and reduced bureaucracy, the authors don't explain what, if anything, the FFA would replace. If it could replace and reduce existing agencies, fantastic! However, if it is another layer of bureaucracy, it should be reexamined.

While world financial markets and firms have been shaken, most economies are returning to some sense of stability. In the US, unemployment remains at 10%+, but credit is becoming easier. Is now the time to establish a new agency? Is now the time to return to previous regulation? The proposition put forth by Ferguson and Kotlikoff should be discussed. Far better to take their advice than that of the current US Congress!

Financial Crisis Primer

**Make sure to read Part II, here.**

While I have written posts about the Freddie/Fannie mess as well as the collapse of Lehman and Bear, I found an excellent synopsis of the situation in the Sept. 19, 2008 print edition of "The Wall Street Journal." Cheap? No. 100% Free. Trade stocks for free on Zecco.com. The Free Trading Community. www.zecco.com

On page A21, Todd G. Bucholz writes in the Bookshelf section an article titled, "The Woe on Wall Street." The article is a review of David Smick's book, The World is Curved. Here is where I found this gem of knowledge:

"The real problem running throughout the system was not a lack of new regulations. It was a lack of skin - that is, skin in the game. Mortgage brokers turned into fly-by-nighters, immune from the effects of reckless decisions. Local bankers, securitized loans and packed them off to some naive investor or to a rating agency manned by analysts who weren't sharp enough to get a job at Bear Stearns or Lehman. Homebuyers who put nothing down or lied about their income could pack up and run off, leaving no skin behind. The entire housing sector began to look like a motel renting rooms by the hour, as johns and hookers snuck out during the wee hours."

Phew, in a paragraph, that's it. Each player had a part to play. In each case, there was a lack of fundamental risk management. Mortgage brokers were setting up loans to folks who shouldn't have had them. The banks lent the money anyway, and sold off the loans to those who didn't have the skill or desire to evaluate them properly. Investment houses saw low interest rates as the sole risk premium, ignoring all that they had learned at Wharton or Harvard. Protect your Medical Identity with TrustedID. $1,000,000 Warranty & Great Customer Service

While I don't wish to understate dishonesty or chicanery, I can't speak strongly enough of proper risk management. I invite all those who study or have studied such things to go back to your Finance books. Look at the sections about risk management. Its worth the read. And to think, I only got my MBA from a state school.