Wednesday, July 18, 2012

Fixing Banking

The banking industry is broken.  That Retired Guy (TRG) is hard pressed to find anyone who will defend the industry, but just in case there are some readers who don't think that the banking industry is broken, read this, and this.  The question now should be 'how do we fix it?', but unfortunately, there has not been much discussion in this area.  TRG actually thinks that just 3 simple, easy to enact laws would completely rectify nearly all of the issues.

1.  Separate Commercial Banking From Investment Banking
It is time to re-enact the bits of the Glass-Steagall Act that separated commercial and investment banking.  It is very simple, commercial banking should include only the following activity:
  • Taking deposits and servicing depositors
  • Investing in conservative loans mostly held to maturity
  • Providing other basic consumer financial services such as credit cards
Investment banking activities can broadly be defined as 'all the other stuff' including underwriting, brokering, trading, investment management and so on.  The fact is that the reasons they were separated by the Glass-Steagall Act in the 1930's are still valid today, and as Barry Ritholtz makes very clear in his book Bailout Nation, it is the regulatory changes that are most responsible for the latest crisis.  The activities of Investment Banking are often by there very nature, high risk, and generally high reward.  Doing these activities lends itself to the type of culture that is incompatible with the activities of commercial banks.  Simply put, if you have a culture of risk taking, you will be a bad custodian of depositors' money.

2.  Mandate That All Commercial Banks Must Be Mutual In Structure
Structure matters.  In a mutual structure, the bank is owned by it's depositors.  This aligns the interests of the organisation with the people who most need the organisation's care and protection.  Mutual banking works, and it exists today in a multitude of credit union organisations.  Generally, they are service oriented, and very conservative in their investments.  There have been problems with credit unions (usually frauds, but that happens in commercial banks too), however, credit unions have NEVER come anywhere near the problems that corporate commercial banks have created.

3.  Mandate That Investment Banks (Hedge Funds Included) Must Be Partnerships In Structure
Partnerships require the managers to own the company completely.  When senior managers become partners, they are required to purchase their partnership share, and therefore, they have a lot (usually nearly all) of their net worth tied to the success of the company.  The investment banks were generally all partnerships before the early nineties, and it worked to keep them small (it's harder to raise capital from a small group of partners then broader corporate shareholders) and risk adverse (partners worried more about risk because the structure provides the ultimate claw back).

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