What do you think of the limited purpose banking proposal advanced by Laurence
Kotlikoff and others? Link to PDF:https://www.aeaweb.org/conference/2012/retrieve.php?pdfid=568
I am skeptical of the ability of government to design banks. It is one thing to write legislation that defines the activities that constitute banking and to issue charters and regulations to these legislatively-defined banks. It is something else entirely to keep banking from breaking out somewhere else.
Consider the money-market fund as an example of what I mean by a common-law bank. Money market funds are not banks as legally defined. They were not eligible for deposit insurance. And yet, I would argue that the regulators hit the panic button in 2008 because of what happened to Reserve Primary money market fund as a result of the Lehman failure. So from a common-law perspective, money market funds had become banks by the time of the financial crisis.
The government may not good at designing banks, but it is more or less obliged to “design”–at least, to describe–the sort of financial institution for which it is providing deposit insurance. It would be OK if banking broke out elsewhere, so long as the taxpayer was not obliged to bail out the depositors/creditors in case of failure.
Unfortunately, it is unclear just who is really covered by a government guarantee. In a “crisis,” who knows whom the government will undertake to bail out? The creditors of AIG? The stockholders and employees of GM? No matter how the government explicitly describes the scope of its guarantee, there will be great uncertainty about how broadly the guarantee really extends, and so about which sectors of the economy the government should (in principle, for the protection of the taxpayer) be designing.
The broader the guarantee, the broader must be the government’s mandate for designing. TBTF is simply creeping socialism.
The logic has a very troubling implication of justifying pre-emptive war on risky free market activities, even if those firms don’t even want a ‘public put option’.
“We’re going to regulate and prohibit certain risks now, because the only reason we let you take those risks in the first place is because private parties voluntarily accept the full cost of failure, as current law says they must. However, we now bl know what was once unclear, that we cannot trust ourselves to resist the sirens’ call to ignore and change that law and intervene in the case of a crisis. The rule of inevitable bail-out is like the ‘common constitution’, unwritten but effectively a supreme law. So the only way we can hope to win that ‘wet our pants’ game of chicken is to refuse to play by banning certain activities altogether.”
In this view, the government can say that letting money markets operate without deposit insurance was, far from inevitable, a one time naive historical error that it won’t make again. From now on its ‘safe or illegal’.
Then again, I suppose that ‘known lack of governmental self-control and commitment to current law’ simultaneously make a public choice-style argument that the state also won’t resist the various temptations offered to rule-makers by the financial sector to relax the general prohibition under a rationalization that ‘this time is different’ or ‘things are safer now’.
That additional logic makes me think that a Minsky-like regulatory ‘sentiment cycle’ of a risk-on / risk-off pendulum is what’s really inevitable.
Would anyone really engage in fractional reserve banking without some kind of government guarantee?
“Shadow banks under LPB will be those without limited liability. They will be permitted to leverage. But the risk of owners’ loss will greatly limit their desire to take on leverage as illustrated by the behavior of the unlimited liability banks in Switzerland. Non-financial corporations that wish to engage in financial intermediation must operate these businesses as LPB mutual funds.”
If I understand what Arnold is saying, he thinks that the shadow banks (operating without limited liability) will develop in such a way that if they are in danger of failing, the government will decide that they need to be bailed out even if the government had previously defined a system saying that they will not do so.
It is interesting that the paper mentions Switzerland’s “unlimited liability banks”. The paper implies that such banks in Switzerland have limited desire to take on leverage, presumably because they do not believe their government will bail them out.
If that is true, how did Switzerland create this expectation that banks will not be bailed out?
IIRC (& I’m a layman so I don’t have all the right words/jargon), Reserve Prime was the only MMF to break the buck (and that only because it was so heavily invested in Lehman). The sponsors (umbrella organization, e.g. The Vanguard Group, Inc. on behalf of its operating subs) of various other MMFs publicly announced their intention to support their MMFs as necessary to maintain their $1 NAV.
The reputational risk of a MMF breaking the buck was sufficient to inspire them to do so.
There is no other investment vehicle that works as well as a MMF for storage of cash distributions and/or sweep of trading proceeds — without generating gains or losses that require tax accounting.
MMFs don’t need government bureaucrats’ “expert” rule-making, which so often (more often than not?) results in consequences that serve only to generate further rules. “Government IS the problem….”