Banking Future From The Past

In last Wednesday’s New York Times editorial page, Amar Bhide, a professor at Tuft’s Fletcher School of Law and Diplomacy, wrote a column, “Bring Back Boring Banks.”  His main thrust is that the Dodd Franks Bill does not do enough to reform banking and that a return to the Glass-Steagall days would be beneficial.  While he is correct that banking should have more defined roles, he doesn’t go far enough to address the whole problem with the reasons for the financial collapse and fails to offer significant improvements in banking.  I do.

Like Professor Bhide stated, Glass-Steagall was passed in 1933 and created the separation of Commercial from Investment Banks.  The Act also established the FDIC, or the Federal Deposit Insurance Corporation, insuring deposits.  The Act also stipulated Commercial Banks could no longer sell securities, like stocks and bonds, which, as some believed, allowed for the free wheeling days leading up to the Crash of 29.  Only Investment Banks could sell stocks and bonds after the passage of Glass-Steagall.

This division in banking responsibilities worked for 66 years until 1999 with the passage of the Gramm-Leach-Biley Act which repealed Glass-Steagall.  The repeal involved essentially one provision: the one preventing a holding company from conducting both Commercial and Investment business.  Basically, this act returned the banking industry to pre-crash operations which fostered Glass-Steagall.  Since 1999, the business lines between commercial and investment banks became more blurred and as Amar insinuated, by 2008 the financial collapse occurred, much like 1929.

Amar is not entirely correct that the Federal Reserve’s original purpose was to be the lender of last resort.  Its original purpose was to stabilize the financial industry as it had been exasperated by the Panic of 1907.  The Federal Reserve’s top priority was to prevent boom and bust cycles. Yet, as Bhide noted, despite its enactment in 1913, the cloudy bank functions in the 1920’s still contributed to the 1929 crash.  Even with the Glass-Steagall provision to divide banking to prevent another crash, I would like to point out to Professor Bhide the Federal Reserve did nothing to prevent the financial collapses in early 1970’s,  the 87 Crash and the 2000 Tech Bubble.

I assert the Fed could have averted the 29 Crash and the Tech Bubble in 2000 had it tightened credit, slowing the economy down gradually rather than letting the bubble expand until it burst.  Many economist blame the Fed for not tightening credit, but for having kept rates low which overheated the economy.

However, I do agree with Professor Bhide that the Dodd Franks Bill doesn’t go far enough in bank reform.  He is right that the line between Commercial and Investment Banks remain blurry.  Here is where I would add recommendations to clarify the functions of each bank interspersed with incentives beneficial to everyone.

I would go further in what I think is my interpretation of Professor Bhide idea; have a two tier banking system, one which is simple so that a “regulator with an average education” can understand, like Bhide’s idea, and one for more sophisticated investors.

I agree with Professor Bhide that the US should return to the Glass-Steagall division of Commercial and Investment Banks. However, I would tweak some of Professor Bhide good ideas, namely “Insuring all deposits but limit risk-taking,” which stifles growth. I would insure all “commercial” deposits only, not investment bank deposits, and raise the insured limit from $250,000 to $500,000.  For large commercial deposits Bhide reveals Dodd Franks doesn’t address, use a percentage of the total dollar amount.  This way, seven and eight figure deposits will receive some, but not all of their deposits back in insurance.  Financially, the Federal Reserve cannot insure all of the Warren Buffets out there.

Besides, investors in either Commercial or Investment Banks will be less apt to risk their non-insured money.  In retrospect, this is good, because without a guarantee, conservative investments principles would return naturally rather than through regulation.   Glass-Steagall is 37 pages long; Dodd-Franks Law is 2,600 pages!  Need I say more?

Professor Bhide ignores the mortgage broker’s role in the housing induced financial crisis.  Restore Commercial Bank activity to its strength; business and home loans.  Outlaw mortgage brokers not attached to a bank.  Mortgage brokers without loan capital, who “found” money to loan from another institution, were the snowball that started the housing avalanche.  Incorporate some of these mortgage brokers into in-house operations, at the Commercial Bank where loan officers loan their own banks money, not someone else’s where there is less accountability.   Tighter restrictions and a return to sound banking principles with due diligence would limit the real estate home loan risk Bhide seeks to avert. 

Disallow banks form re-entering the low income housing market. Low income loans can be originated with FNMA, Freddie, FHA etc. using stringent lending practices.  One is government operated; the other is privately managed, so keep them separate!

Here is where I go further than what Bhide mentions.  Increase the Commercial Banks’ percentage of assets allowed to trade securities.  Currently, under the Dodd Frank bill as the Volker Rule, Commercial Banks can utilize only 3% of their assets for proprietary trading.  Allow Commercial Banks to invest a higher percentage of their assets but, in limited trading instruments, stocks and bonds for example, and only in the secondary market. Depositors with average intelligence like Bhide mentions can understand this simple financial activity.

Then, find a way for the banks to share these profits with all depositors without having to own shares in the banks stock.  If dividends were tax free, a bank’s dividend payment may increase, making stock ownership worthwhile, but otherwise, a profit sharing plan would benefit all.  The ability for the retired, fixed income and low income depositors with liquidity concerns to participate in some of the profits will help them accumulate wealth, which is integral to our capitalistic society.   It is the least the bank can do for their deposits.  Instead of redistributing wealth through taxation, the government should use laws and incentives to make it beneficial for businesses to distribute profits.

This profit sharing solution would also alleviate the distrust and disconnect between Wall Street and Main Street.  Wall Street uses Main Street deposits to make money, but then they keep the profits all to themselves.  Commercial Banks should be reconfigured in a way where all depositors could share in profits, but still have deposits guaranteed.

For the Investment Banks, deposits should not be guaranteed.  Depositor’s cash will be used for speculative and intricate investments for the sophisticated investors.  Profit sharing plans should be initiated according to the Investment Bank.  No guarantees, no insurance, just deposits used for investing in start-ups, Initial Public Offerings, trading etc.

This way, a low income person starting out or a retired couple on a fixed income can deposit their money in a commercial bank where deposits are guaranteed.  With Banks distributing their profits to all depositors, upward mobility, prosperity and increased disposable income can be achieved.  Who knows, maybe a person can eventually open an account at an Investment Bank after acquiring the knowledge to be involved at that level of investing.

With this two tier banking system, Commercial Banks can guarantee and grow deposits with stringent loan operations, limited investment vehicles and sound banking procedures for the beginner and intermediate investor who possess a basic understanding of the financial markets, all with FDIC insurance.  The two tier system also allows for the Investment Bank to make wildcat investing, high risk, and high reward investments for the experience sophisticated investors using intricate investment vehicles.  So there we have it; two banking choices with clarity in function, operation and benefits; with clear distinct differences and functions available to either consumer, as it should be!

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