Larry Kotlikoff responds on limited purpose banking

by on August 4, 2010 at 7:23 am in Books, Economics | Permalink

You can read his reply here.  Note however that my criticisms explicitly are directed at narrow banking more generally, most of all my own (previous) version of the idea, not at the specific version of Kotlikoff's proposal.  There is one particular topic I did not deal with, and on it I will quote Kotlikoff reproducing my critique and responding to it: 

TC: A lot of what current banks do would be replicated by non-bank commercial lenders and the risk of the banking sector would be transferred somewhere else. 

LK: You missed the key point that all incorporated financial intermediaries have to operate as mutual fund companies. There are no “non-bank commercial lenders” unless they operate as proprietorships and partnerships and their owners have their houses and yachts on the line. The risk of the banking sector is reduced because we set it up to eliminate any chance of bank runs and gambling by the banks with the taxpayers’ chips. Recall, the mutual funds are 100 percent equity financed at all times and in all situations. 

TC: Ideally, these non-bank lenders would engage in greater “maturity-matching,” but if banks will exploit the moral hazard problem won’t these lenders exploit it too?  

LK: The only financial intermediaries who can operate under Limited Purpose Banking according to the current rules of the road are private banks with no limited liability. The lack of limited liability will eliminate the moral hazard problem. 

I am not inclined to see unlimited liability as a practical alternative.  How many businesses supply commercial credit?  Trade credit?  Credit by any other name? — namely contracts involving derivatives, annuities, insurance, repurchase agreements, etc., with intertemporal payments and embedded interest rates in the prices.  Would they all have to give up limited liability?  Or would we end up channeling more financial intermediation through indirect credit transactions, while maintaining limited liability?  A version of this dilemma is experienced regularly by systems of equity-based Islamic banking..

Second, unlimited liability creates a pecuniary externality across shareholders.  Who wants to be the remaining "fat cat" shareholder?  Why should Bill Gates ever invest?  Non-mutual fund banks will end up owned by thinly capitalized individuals or entities, thereby defeating the purpose of unlimited liability while at the same time raising transactions costs.  Walter Bagehot made this point, see also Joseph Grundfest, here is Hansmann and Kraakman with a reply.  Alex very ably surveys the main arguments in an MR post.

Unlimited liability is fine for small-scale, private banking, especially in the international sector where tax evasion is a motive and the banks aren't fully part of any standard regulatory network.  It doesn't work to force it on such a large sector of the economy as most commercial credit and non-bank lending.

In sum, I do not believe that narrow banking proposals benefit from being bundled with unlimited liability for other lenders.

Luis Enrique August 4, 2010 at 7:57 am

Tyler

given that there are problems with the existing system and problems with every proposed reform of it, how close would you place Kotlikoff’s ideas to the best of the bunch?

Taylor August 4, 2010 at 8:33 am

This is the first time I’ve heard of such a proposal. So far as I understand it I agree with Tyler – the risk will be transferred to the mutual funds.

Sure, the legal nature of the interest in a mutual fund is “equity” rather than “debt” but the economic function is the same.

So I suspect the following things are likely to happen:

(1) there will be insufficient investment in such funds because investors will not want to lock up equity in “closed-ended” mutual funds (those from which they cannot in fairly short order redeem their interests);

(2) mutual funds will end up mismatching their assets (secured loans) and liabilities (redeemable equity), to attract more investment from those who want redeemable investments (just like “open-ended” hedge funds and property funds did before the crisis). There will be runs by investors (redemptions) when the fund is perceived to be at risk. These runs will undermine confidence in such mutual funds, leading to insufficient future investment.

Andrew August 4, 2010 at 10:02 am

At base, you take the responsibility of watching bank management away from the depositors and give it to the FDIC or whoever. What is magic about this? Nothing. You can move back in the other direction in a macro or micro way. I’m not sure how we got from capital at risk to unlimited liability. The same capital is at risk, it’s just that we call depositors taxpayers when the FDIC funks up.

B.B. August 4, 2010 at 12:07 pm

A few points.

Limited liability is necessary for publicly traded shares. Otherwise, those with money would never buy shares.

But private partnerships are different. When Goldman Sachs was a partnership, it had a better reputation and had fewer scandals. By going public, it could grow and become too big to fail. The management had moral hazard: if they blundered, the shareholders took the hit. The opposite was true when it was a partnership.

The parts of Wall Street that stayed partnerships did okay in the Crisis. The failures happened to publicly traded investment banks. Notably, the hedge funds, which floated out the crisis, are not publicly traded.

The more I think of Kotlikoff’s proposal, the more I like it. But I think limited banking would have to be phased in.

First step: the amount of bank reserves at the Fed is about the same as checkable deposits. Let’s have 100% reserves right away on all checkable banks acounts. The Fed would hold T-bills against the reserves. Let the Fed pay interest on reserves, and banks be allowed to pay interest on checkable accounts. Then let all checkable accounts be insured 100% by the FDIC. This wouldn’t stop recessions, but it would eliminate runs on checking accounts and it would guarantee the payments system.

Second, all sovereign debt and muni debt would be held in mutual funds, not directly held by banks. Would Europe have the big deal with the debt of the PIIGS if that debt was held in mutual funds instead of being on bank balance sheets? I think not. Europe doesn’t have a sovereign debt problem; it has a bank problem.

Third, Fannie and Freddie would be converted to mutual funds for conforming mortgages. F&F’s only role would be to collect and distribute information on mortgage borrowing. All risk of mortgage default would rest on the ultimate borrower, not on F&F and not on the taxpayer.

Fourth, money market mutual funds will be forced to mark to market. No more preserving NAV. There will be no “buck” to “break.” The illusion that principal is guaranteed for MMMFs needs to be ended.

It is a start.

Gu Si Fang August 4, 2010 at 5:20 pm

@ B.B.

“Limited liability is necessary for publicly traded shares. Otherwise, those with money would never buy shares.”

I got this answer once when asking why limited liability was so universal. There is some truth to it, but no more than that. Unlimited liability in traded share is not an issue for large, professional investors. And small, individual investors can invest in mutual funds who can then buy traded shares and bear the unlimited liability risk for them.

mulp August 4, 2010 at 9:22 pm

I am not inclined to see unlimited liability as a practical alternative.

Lloyd’s of London was certainly unlimited liability membership for a couple of centuries, much to the surprise of some of its members in the 90s….

But hey, those were the foolish English socialists who put their personal wealth at risk, while no risk taking American capitalist would risk his own fortune – that would be like socialism.

Laurence Kotlikoff November 16, 2010 at 12:24 am

Hi Tyler,

I just saw your reply to my reply.

You say, “I am not inclined to see unlimited liability as a practical alternative. How many businesses supply commercial credit? Trade credit? Credit by any other name? — namely contracts involving derivatives, annuities, insurance, repurchase agreements, etc., with intertemporal payments and embedded interest rates in the prices. Would they all have to give up limited liability? Or would we end up channeling more financial intermediation through indirect credit transactions, while maintaining limited liability? A version of this dilemma is experienced regularly by systems of equity-based Islamic banking..”

I think we are talking past each other again. I’m not suggesting that banks operating with unlimited liability would be particularly important in a world of Limited Purpose Banking. I’m suggesting the opposite — that they would either be very small and unimportant or would be extremely careful about their borrowing. I think the ownership of such banks would be very concentrated and probably be either sole proprietors or small partnerships with a couple of partners. No one will want to be a small partner in a company that could experience a huge claim and, as a result, lose one’s house.

So let’s get back to the main point, which is how the vast majority of financial intermediation would operate under Limited Purpose Banking. This is not Islamic Banking. People can borrow and companies can borrow. They can borrow from each other or from mutual funds. Mutual funds can’t borrow. And incorporated companies can’t borrow and lend; i.e., if they want to be GMAC they have to operate as a mutual fund.

Please take a look at the last two chapters of my book where I explain Limited Purpose Banking. I’m not spending any time on unlimited liability banks because I expect them to be trivial in size and scope. I do explain quite clearly why mutual funds will work just fine in conjunction with the single federal regulatory agency that would hire companies to verify, rate, appraise, and disclose the securities held by the mutual funds.

best, Larry

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