Adair Turner’s Misplaced Concerns About Limited Purpose Banking

To Lord Adair Turner
Chairman of the Financial Services Authority

Dear Adair,

Your chapter in the just released Future of Finance (http://www.futureoffinance.org.uk/) is masterful. But the very strong concerns you express about Limited Purpose Banking (LPB) are, I believe, misleading, misdirected, and rather surprising since LPB delivers precisely the reforms you advocate.

Let me respond in italics to the specifics of what you wrote (the bold text) and then indicate why LPB does what you say you want.

Abolishing banks: 100% equity support for loans. Professor Kotlikoff‘s proposal, in contrast, suggests a truly radical reform of the institutional structure for credit extension.

In the U.S., mutual fund companies already constitute one third of the financial system and facilitate/intermediate a very large volume of lending to companies, governments, and homebuyers. So “truly radical” is a bit strong for my taste. Also, individual mutual funds are, except for the letters used in their name, banks. The difference is that they are safe banks or, if you like, utility banks, which that “truly radical” economist Meryn King has advocated. They are safe insofar as they are never leveraged in any state of nature. I chose the word “banking” in Limited Purpose Banking to convey the point that we need banks, but ones that stick to their legitimate purpose – financial intermediation, not gambling with the taxpayers chips and the economy’s performance.

The fact that mutual fund companies were exempted, to my knowledge, from any additional regulation under Dodd-Frank means that the U.S. Congress views mutual funds as a safer banking system. Their expansion relative to traditional banks is surely fostered by this bill. (This and the creation of the Consumer Financial Protection Agency are the two features of Dodd-Frank that I like.)

This is not to say that mutual funds in their current form are what I advocate. As I’ve written, no mutual fund, except cash mutual funds, which hold only cash, would be backed to the buck. Open-end funds would have automatic in-kind redemption or closed-end conversion triggers in the face of redemption runs. I’m strongly opposed to the government’s guaranteeing the buck of any mutual fund besides cash mutual funds, where there is no need for the guarantee since the cash is in the vault, physically or electronically.

Lending banks would become mutual loan funds, with investors sharing month by month (or even day by day) in the economic performance of the underlying loans. This is equivalent to making banks 100% equity funded, performing a pooling but not a tranching function.

This is not a real difference with the current system. Under the existing system, investors in banks, be they stockholders or creditors, are sharing, day by day, in the performance of the banks’ underlying loans. Citigroup bonds, for example, float on the market. While it’s true that deposits don’t explicitly float, they do implicitly insofar as when banks fail, taxpayers have to cover the insured deposits. Hence, every day that the performance of a standard bank’s loans change, the value of the contingent liability facing taxpayers changes.

Also, as I discuss in Jimmy Stewart Is Dead, mutual funds with clearly defined sharing rules (a CDO is such a mutual fund) permit the mutual fund shareholders to leverage each other. So tranching is definitely part of what I’m proposing provided the sharing rules among the parties are very simple and clear and there is no liability to any parties beyond the mutual fund owners.

And it would clearly exclude the possibility of publicly funded rescue: if the price of loan fund assets fell, the investors would immediately suffer the loss.

I disagree. As I say in the book, under Limited Purpose Banking the government, if it so chooses, can intervene directly to lower interest rates to particular borrowers by buying shares of the mutual funds purchasing their paper. The mutual funds, themselves, would never need to be publicly rescued, but I believe you are referring to the government rescuing particular borrowers who might not otherwise get funded at “reasonable” interest rates.

The most common reason the price of a loan fund falls is that market interest rates rise. But a rise in market interest rates lowers the market price of outstanding bank debt. And, for that matter, it lowers the implicit market value of deposits to the extent that they are going to be withdrawn in the future as opposed to immediately.

You appear to think that the current financial system is delivering safety for the common man because he has the assurance that his checking account is safe. Under LPB, the common man can invest in cash mutual funds or short-term government bond funds, so he can get this same type of safety.

And, with all due respect, you seem to be missing the fact that risk is hitting the common man through the back door -- via the potential for job loss, loss of retirement assets, tax hikes, and future inflation.

But it is not clear that such a model would generate a more stable credit supply.

The stability of the supply of credit is, from my reading of the current and prior credit crises, very closed tied to the stability of the financial system. When major financial companies fail, the specter of this flips the economy to a bad equilibrium (coordination failure) of the type described by Peter Diamond and others in which firms expect and, then, collectively create bad times. In addition, the credit market flips to a bad equilibrium of the type described by Stiglitz and Weiss in which lenders expect only bad borrowers and, then, set rates high enough to produce that outcome. Limited Purpose Banking ensures that there will never again be financial failures on a small scale, let alone a large scale. As you know, Limited purpose banks can’t go bankrupt since they are 100 percent equity financed.

As Section 4 argued, a system of securitized credit combined with mark-to-market accounting can generate self-referential cycles of over and under confidence.

Regardless of the accounting rules and disclosure, the market is going to mark assets to market. Lehman's chief, Dick Fuld, said his assets were very safe and far exceeded his liabilities, but the market said otherwise. So limiting mark-to-market accounting is not really feasible and questioning it (which I’m not sure you mean to) is shooting the messenger.

As for self-referential cycles of over- and under-confidence, it is the bankers, not the individual investors, who are, it seems to me, alternatively gunning the system and running it down. You want bankers to manage financial risk for individuals and the economy. They aren’t to be trusted in this role. I don’t want our children’s economic futures in the hands of the salesmen and lawyers who end up at the top of financial behemoths. Jimmy Stewart, in short, is dead.

But the main factor I feel you overlook in referencing self-referential cycles is the lack of transparency. Your 86-page paper mentions this word only three times and the word disclosure only once. I think the primary reason the crash of 2008 hit with such force was not the fact that housing prices had risen too much due to irrational exuberance (indeed, they fell much less than stock prices), nor that too much credit, per se, was extended, but that too much fraud was involved in the extension of credit.

Had Lehman, Bears, Merrill, Countrywide, … been forced to send their mortgage applications to the Federal Financial Authority (the sole regulator I proposed under LPB) to have the applicant’s past income verified (via income tax returns), have the applicant’s current job and earnings verified, have the applicant's credit rating verified, have the applicant’s proposed collateral (the home to be purchased) independently appraised, have the applicant’s credit rating verified, and have the applicant’s application (his mortgage) independently rated, and had all this been posted on the web in real time, trillions of dollars in toxic loans would never have been originated. It’s the systematic production of fraudulent securities that’s at the heart of what happened. Your chapter mentions the word fraud not once.

This is not to claim that self-referential cycles can’t arise. As we both know from the work of Samuelson, Cass, Shell, Calvo, Farmer, and many others, models with rational agents (what I’d call neoclassical models) can exhibit multiple equilibria paths of asset prices even absent any of the information/coordination issues referenced above. LPB -- a perfectly safe banking system in which all securities purchased, held, and sold by the financial intermediaries are independently vetted and disclosed – won’t keep asset prices from moving in what seem to be crazy ways (just consider today’s long-term U.S. Treasury bond prices), but it will stop bubbles spread by lies and crashes spread by panic over fraud. Under LPB, Madoff’s valuation would never had hit $60 billion. It wouldn’t have hit 2 cents since Madoff's fund would have been a mutual fund subject to third party custody and the custodian would have blown the whistle.

And while Kotlikoff‘s loan funds might seem to abolish the maturity transforming bank, with investors enjoying short term access but not capital certainty, investors would be likely in the upswing to consider their investments as safe as bank deposits.

There are thousands of fixed-income mutual funds whose prices fluctuate by the minute. The owners of these funds don’t view them as safe as bank deposits. And under LPB, money market funds would clearly break the buck. Indeed, I would force the mutual fund companies to reference them as short-term commercial paper funds and make every shareholder sign a one-sentence statement in giant letters – “I understand that this is not a cash mutual fund, that it is risky, that it can break the buck, and that I may, therefore, lose the money I invest.”

Investments in loan funds would therefore be likely to grow in a pro-cyclical fashion when valuations were on an upswing and then to run when valuations and confidence fell, creating credit booms and busts potentially as severe as in past bank-based crises.

The picture being drawn here is of the public purchasers of mutual funds seeing returns on fixed income going up and borrowing on their homes to invest more in these funds in a craze to make a few more basis points. But what we know is that households tend to buy and hold, while bankers tend to churn their portfolios. I just don’t see this as a valid objection to LPB relative to the current system.

The essential challenge indeed is that the tranching and maturity transformation functions which banks perform do deliver economic benefit, and that if they are not delivered by banks, customer demand for these functions will seek fulfillment in other forms.

As previously indicated, tranching (some investors taking more risk than others within a fund) is part of LPB. Indeed, CDOs are, to repeat, effectively mutual funds with this property. The fact that so many CDOs invested in toxic loans is because the loans were fraudulent, not because the loans were risky. We don’t say that stocks are toxic, even though the stock market has fluctuated dramatically since its peak. We say mortgage-backed securities are toxic because borrowers’ incomes were misstated, collateral values were misstated, and credit worthiness was misstated.

Furthermore, tranching is just one way for some people to take more risk than others. A simpler way is for more risk-averse people to simply invest in mutual funds that purchase safer asset. I.e., tranching is not the end all and be all of risk allocation in the economy.

As for maturity transformation, the liquidity risk-sharing featured in the Diamond-Dybvig model can be achieved by households simply holding a portfolio of mutual funds some of which specialize in short-term bonds and others that invest in long-term bonds. I.e., a model with such investments provides the same risk sharing as their model. But it does so without the risk of a bank run.

The Diamond-Dybvig paper claims that governments can insure deposits to avoid the bank runs associated with their mechanism of having banks return deposits on demand. But their paper assumes real deposit insurance when only nominal deposit insurance exists in the real world and it undergirds this assumption with the assumption that the output of the economy is unaffected by bank runs, which is clearly not the case.

We need to find safer ways of meeting these demands, and to constrain the satisfaction of this demand to safe levels, but we cannot abolish these demands entirely.

Again, LPB permits tranching within any given mutual fund and liquidity risk-sharing (the raison d’être of maturity transformation) via diversified holding of short- and long-term fixed income mutual funds.

There is therefore a danger that if radicalism is defined exclusively in structural terms – small banks, narrow banks, or the replacement of banks with mutual loan funds – that we will fail to be truly radical in our analysis of the financial system and to understand how deep-rooted are the drivers of financial instability.

The truly deep root of financial instability is the use of the claim of proprietary information to conceal the production and sale of fraudulent securities. The assets we call toxic today have that title for a reason.

An exclusive focus on structural change options, indeed, reflects a confidence that if only we can identify and remove the specific market imperfections, which prevent market disciplines from being effective, then at last we will obtain the Arrow-Debreu nirvana of complete and self-equilibrating markets.

This is the last thing I believe. I’m don’t believe we’ll achieve any Arrow-Debreu nirvana. LPB will fix some huge problems and restore the rule of law to the financial system. It will do great good. It’s worth taking very seriously.

In the words of George Shultz it’s “simple, clear, and, most of all, effective.” In the words of George Akerlof, LPB “offers an amazingly simple financial fix to prevent an even worse crash,” in the words of Edmund Phelps, LPB “is one of the best visions to surface so far,” in the words of Simon Johnson, LPB “is beyond appealing; it is compelling,” in the words of Niall Ferguson, LPB “is clearly the best available remedy,” in the words of Kenneff Rogoff, LPB “is a blueprint for how to fix it (the financial system) from the ground up,” in the words of Jeff Sachs, LPB is “a powerful reform that stops banks from gambling and restricts them to their legitimate purpose,” and in the words of Martin Wolf, in endorsing LPB, “cautious reform is the risky option.”

None of these and other prominent economists who have stuck out their necks in extremely strong support of LPB believe Limited Purpose Banking are naïve or that it would produce Arrow-Debreu nirvana.

If instead we believe that liquid financial markets are subject for inherent reasons to herd and momentum effects, that credit and asset price cycles are centrally important phenomena, that maturity-transforming banks perform economically valuable but inherently risky functions, and that the widespread trading of credit securities can increase the pro-cyclicality of credit risk assessment and pricing, then we have challenges which cannot be overcome by any one structural solution.

I also believe each of these things and a lot of other things about the current system. That said, LPB combines a large number of structural solutions in one simple system. What I don’t believe is that this statement and the one about Arrow-Debreu nirvana are serious critiques of Limited Purpose Banking.
Adair, let me conclude by connecting what it seems you are advocating in your paper (which I generally like very much) to LPB.

You raise the need for financial disclosure. LPB provides full disclosure.

You raise concern about too big to fail. LPB has small banks (the individual mutual funds) none of which can fail.

You say we need non-conflicted credit rating. LPB provides non-conflicted credit rating, appraisals, third-party custody, income and employment verification, etc.

You advocate higher capital requirements. LPB has 100 percent capital requirements.

You want credit originators to have skin in the game. Under LPB the investors have all the skin in the game. And they get to see on the web in real time precisely where this skin is invested.

You say the market wants simple, transparent structures. LPB provides the simplest and most transparent structure.

You want firewalls so that one financial intermediary doesn’t bring down another. LPB has a firewall around each mutual fund. Losses of any mutual fund have no impact on any other mutual fund.

You want securitization, but simpler securities. Mutual funds are, themselves, very simple securitizations.
And since the Federal Financial Authority would rate complex securities as more risky, they would likely disappear form the market.

You want financial stability. LPB offers financial intermediaries who cannot fail. I.e., it puts a definitive end to the banking crises that have plagued global economies for hundreds of years.

You oppose radical change. But the current financial system is not safe at any speed. Tens of millions of unemployed workers and newly broke retirees can attest to this. They are looking for real change, not maintaining the status quo with some minor tweaks (a la Dodd-Frank), which is as radical as it gets.

Adair, climb onto the ramparts. We need you.

My best, Larry