Thursday, November 12, 2009

The Public Purpose of Banking

While Lloyd Blankfein claims bankers are worth Billions, even as they destroy Trillions, it's worth taking a look at what the public purpose of banking is. Chicago economists, sit back down, the public purpose of banking is not to enrich their shareholders any more than the public purpose of pharmaceutical companies is. Capitalism works by enriching owners as they compete to provide some value to customers. So, what is the value that banks deliver to their customers?

First, what is a bank? My definition is simple and goes to the heart of their public purpose: a bank is an entity that has a reserve account at the Fed. That is it. If you have a reserve account at the Fed, it means you can lend unconstrained by your reserve balance. Briefly, this is how it works:

1. You make a loan. This debits your reserve account, and you credit a receivable account.
2. The loan gets deposited, which credits that reserve account, and credits a liability. Note how the loan created the deposit, not the other way around.
3. If the loan and the deposit are made at the same institution, that institution has no net change to its reserve levels. If the loan and deposit were made at different institutions, then the institution short reserves borrows what it needs from the institution long reserves overnight. That's it.

If you or I make a loan, we cannot use the reserve credit that the corresponding deposit creates to top up our own reserve levels. Thus this clear, operational difference between banks and non-banks.

Ultimately, the Govt creates all reserves, so why not just have the Govt make loans directly? Because we do not want the Government to make credit decisions, they are too likely to dole out money to politically connected constituencies, while starving worthwhile, but unconnected borrowers. You can see this today, as banks and unions get Billions, while shop keepers, dry cleaners, manufacturers, and restauranteurs shutter their businesses and go on the dole. An institution that makes loans it knows will not be paid back is not making loans at all, it is making gifts, and the operational bankruptcy of the FHA is a great example of this in action. Many adjectives come to mind: corrupt, wasteful, abominable, unfair, fraudulent, etc. This is the opposite of Responsible Governance. Barry, we really expected more.

So, to keep responsible lending, we put private capital infront of public capital and ask that private capital take the first loss on loans it makes which turn out to be bad. Ultimately, taxpayer money is there as backup, but it should not be directing investment. We call this institutional arrangement a "bank".

This simple sensible construct is utterly lost on policy makers and the commentariat alike. For banking to do the job it is meant to do (ie. make loans that will be paid back), a bank should be required to keep all loans it makes on its books until maturity. It should be forbidden to participate in any secondary markets, in any way. It should not run a prop trading desk. It should not sell insurance. It should not have a fee-for-service business. It should simply conduct its own credit analysis, make loans, and service them. And in return for providing this public purpose, a bank shall have a reserve account at the Fed.

2 Comments:

Blogger Mike Sankowski said...

Frackin' Brilliant

11:24 PM  
Blogger Curt said...

I have been writing about this solution for six or seven years.
It is all the regulation that we need to prevent another systemic incident like we have just experienced.

You haven't taken this though all the way though. Keep running with it.

my blog is capitalismv3 dot com

5:39 PM  

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