Tuesday, December 30, 2008

Are Banks a Relic in Need of Replacement?

Banks serve a very useful function, but they have some unfortunate properties. Should they be replaced and what would the replacement look like?

***This is kind of long, so you can scroll down to the “Punchline” if you don’t want to read it all***

There are two problems with banks. First, they have the occasional tendency to go insolvent. This would not be an extraordinary problem nor unique to banks, as many companies go out of business all the time. The second and unique problem for banks is that so many go insolvent at the same time. A domino effect can arise where one bank’s closure can drag down other banks with it. When too many banks fail, they drag each other down and we get financial panics like the one we have had in recent months.

Where you believe in the Austrian Business Cycle or another explanation, banks have a tendency to go through cycles where the economy is growing nicely and banks start to get careless with their loans. They also loan out money to each other. When they have ample cash on hand, but no worthwhile borrowers they loan the money to other banks. When the economy slows, these careless loans start to default and banks start running low on reserves. As some banks start to approach insolvency, they start calling in loans they have made to other banks. Some of these banks are not in good financial shape either, bringing them closer to insolvency as well. A wave of insolvencies can lead to widespread panic as depositors begin pulling out their money.

A bank normally spends its time taking your deposits and lending them out to entrepreneurs wishing to open or expand a business. Individually we lack the time or experience to decipher good investments for local businesses so we accept a low interest rate. The bank, uses its intelligence, finds good business deals and loans money out at a higher interest rate. The difference between the low interest paid out and the high interest paid in is their revenue stream.

When a panic strikes, the normal functions of a bank are suspended. A bank can’t afford to make many loans because they need to keep cash on hand to prevent a bank run. They are stuck in a Catch-22 where they need to hold cash to prevent insolvency, but they are losing their revenue stream because they are not making enough loans. If the panic lasts too long they will fail.

The kind of banking that we are used to is called fractional reserve banking. The bank is only required to hold a certain portion of deposits as a reserve, say 10%. This is what leaves them susceptible to bank runs. If banks held 100% reserves bank runs would be impossible, and thus financial crises, at least for banks, would be impossible. However, 100% reserve banking would not allow banks to operate with their standard model of interest baring deposits and interest paying borrowers. This is an important cog in the machine of our current economy, which connects capital and productive ideas.

However, there is a form of 100% reserve “banking” that operates without the risk of the domino effects inherent to fractional reserve banking. This form also works very well at connecting capital with productive ideas. This form is known commonly as mutual funds. When T. Rowe Price sells you a mutual fund, T. Rowe is not practicing any leveraging like a bank. That is, they are not putting themselves at financial risk when placing your money with various companies. They merely act as an intermediary between you, the holder of capital, and the entrepreneur, the productive user of capital. T. Rowe Price collects an asset management fee and possibly a few others to cover their costs and make a profit for themselves. They use their special business knowledge to act as a more efficient conduit for the economy. If they perform worse than their peers costumers withdraw their money and assets and place them under someone else’s purview.

When looking at the housing mess and so many of distortions and mistakes made we can see the damage and the domino effects of leveraging. Lending companies borrowed at low rates, and lent at high rates to sub-prime borrowers. When no one wanted to buy their sub-prime loans anymore their business model died and a wave of companies went bankrupt. Banks were lending out as well, assuming that borrowers were more credit worthy than they really were. When defaults rose and the value of their loans fell, their reserves were suddenly insufficient. As we saw, many closed or were bailed out by the government.


The question that this begs in my mind is “Why are there no mortgage mutual funds?” Why can’t I go to T. Rowe Price and say, “I want to put $20,000 into a mortgage fund that lends to people with credit scores between 675 and 700 and 10% down”? If this was the model, we would not have seen massive bankruptcies in the mortgage lending business. We would not have seen massive problems in the banking sector. Sure, I would have taken a hit with the large number of foreclosures, but this would not have created the systemic risk that the traditional fractional reserve banking system creates.

Setting up a system where the intermediary only acts as a steward collecting a service fee eliminates much systemic risk, without sacrificing the efficient capital allocation properties of banking. It may also limit the effects of interest rate manipulations by the Federal Reserve on the housing industry, which would reduce boom-and-bust cycles. Perhaps this is the lesson we should learn from our recent afflictions.

A few months ago I actually read an article about a hedge fund that was planning to do this. Unfortunately, I did not keep the link. If you know of a mutual fund that is doing this, let me know. If I had money, I might even try to start a business on this model.

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