Restructuring the Banking System to Improve Safety and Soundness

• This paper provides a specific proposal to limit the financial activities that are covered and thus subsidized by the government safety net in order to protect the financial system and the economy. The U.S. safety net, which consists of central bank loans to solvent but liquidity strained banks and federal deposit insurance, was developed in the early 1900s to protect commercial banks. • The safety net originally was limited to commercial banks because they are critical to an economy’s overall health and growth. Their core activities of making loans funded by short-term deposits provide essential payment, liquidity, and credit intermediation services. But banks also are inherently unstable because depositors will “run” if they believe their bank is in financial trouble. • While the safety net solves the instability problem, it also creates incentives to take excessive risk because it subsidizes banks. With safety net protection, depositors and other protected creditors are willing to lend to banks at lower interest rates, given the amount of risk. This cheaper funding and reduced market discipline creates incentives for banks to make riskier investments and increase leverage. The subsidy and associated incentive to take greater risks have grown substantially over the past 30 years because the activities the safety net supports has expanded beyond the core banking activities considered necessary to protect. • The recommendation in this paper is to limit the safety net – and thus its subsidy – to what the safety net should protect by restricting banking organization activities by business line. Under the proposal, banking organizations would continue to provide the core services of commercial banks – making loans and taking deposits to provide payment and settlement, liquidity, and credit intermediation services. Other allowable services would be securities underwriting, merger and acquisition advice, trust, and wealth and asset management. Banking companies would not be allowed to conduct broker-dealer activities, make markets in derivatives or securities, trade securities or derivatives for either their own account or customers, or sponsor hedge or private equity funds. • The difference between what banks would and would not be allowed to do is based on the principle that beyond their core services, they should not conduct activities that create such complexity that their management, the market, and regulators are unable to adequately assess, monitor, and control bank risk taking. Current activities conducted by banks that would be prohibited for them, such as trading and market making, are important to the economy. But they should not be subsidized by the safety net because it causes their overproduction, and therefore imposes unnecessary risks and costs on the financial system and economy. In fact, by removing the safety-net’s protection for activities such as securities and derivatives market-making, the market for these services should become more competitive and less dominated by the largest investment banks, which currently are all affiliated with commercial banks. • The benefits of prohibiting banks from conducting high-risk activities outside of their core business, however, would be limited if those activities continue to threaten stability by migrating to the “shadow” banking system. Shadow banks are financial companies not subject to prudential supervision and regulation that use short-term or near-demandable debt to fund longer-term assets. In other words, shadow banks essentially perform the same critical, core functions as traditional banks, but without an explicit safety net or prudential regulation. As a result, the shadow banking system is susceptible to disruptions that threaten financial and economic stability and lead to additional implicit government guarantees and the associated incentive to take excessive risks. • To mitigate the incentive for shadow banks and other financial companies to take excessive risk and the associated potential systemic effects, this paper makes two additional recommendations. First, money market mutual funds and other investment funds that are allowed to maintain a fixed net asset value (NAV) of $1 should be required to have floating net asset values. Second, bankruptcy law for repurchase agreement collateral should be rolled back to the pre-2005 rules, which would eliminate mortgage-related assets from being exempt from the automatic stay in bankruptcy when a borrower defaults on its repurchase obligation. • The problem with fixed NAVs and current bankruptcy law is they provide special treatment – that is, they essentially subsidize – short-term funding. As with the safety net for banks, the subsidy leads to the overproduction of risky shadow banking activities. By reining in this subsidy, these two recommendations should greatly curtail shadow banking activities by exposing shadow bank creditors to the true costs of their investments.