Kotlikoff Responds to Tyler Cowen, Again

Here is a review of the bidding: Larry Kotlikoff and I proposed a radical reform of the financial system — in which financial intermediaries would specialize in connecting savers and investors, but would not themselves engage in leverage or make risky investments with other people’s money without their consent. Larry has subsequently expanded on the idea in the book, Jimmy Stewart is Dead.

Tyler Cowen criticized the proposal at his blog. Larry responded here. Tyler rejoined here. And Larry makes one last rebuttal below the fold.

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

Larry: Yes, essentially all financial intermediaries would operate as corporations and would, therefore, have to operate strictly as mutual fund companies under Limited Purpose Banking. In focusing, in your reply, just on financial intermediaries who would operate with unlimited liability, you are focusing on, perhaps, .0001 percent of the financial intermediation that would arise under Limited Purpose Banking.  

Tyler: 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?  

Larry: In Jimmy Stewart Is Dead, I describe how incredibly simple and safe it is for financial intermediaries to provide all forms of credit, be it commercial credit, credit card balances, mortgages, or trade credit, and all forms of insurance, including derivatives, such as CDSs and CDOs, annuities, and life insurance, via mutual funds.  

So, the answer to your question “Would they all have to give up limited liability?” is no. Virtually all financial intermediaries would go about their business of intermediating, which includes mediating credit as well as risk-sharing arrangements, by becoming incorporated mutual fund companies. 

Tyler: 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.

Larry: Well there is no dilemma with respect to Limited Purpose Banking. I can’t speak to Islamic banking. I don’t know enough about it. But I don’t believe it is very closely connected to what I’m proposing. I’m taking the leverage out of intermediation. But non-financial companies and individuals are free to borrow under Limited Purpose Banking. They simply borrow through mutual fund companies.   

If you look at today’s mutual fund industry, you’ll notice that its intermediating about one third of all financial exchange. Over time that glass will become three-thirds full. Dodd-Frank exempted mutual fund companies, so they will expand relative to the existing leveraged banking system over time. I.e., I think Limited Purpose Banking will take over, if not via explicit legislation, then by the government clamping down on what we now have, namely an incredibly fragile system of finance.  

Tyler: Second, unlimited liability creates a pecuniary externality across shareholders.  

Larry: There are no shareholders in unlimited liability companies, so I’m puzzled by this statement. There are partners, all of whose personal wealth is on the line if the company borrows and can’t repay.  

Tyler: Who wants to be the remaining “fat cat” shareholder? Why should Bill Gates ever invest?  

Larry: I don’t follow this.  

Tyler: 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.  

Larry: Unlimited liability banks, which again, will likely be tiny or non-existent, under Limited Purpose Banking will likely be highly capitalized because their owners’ yachts, cars, homes, paintings, future earnings, etc. will be on the line to repay their creditors.

Tyler: 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.

Larry: I’ll take a look at these references, but I think we are talking past one another here.  Your idea of unlimited liability and mine are very different. 

Tyler: 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.

Larry: Please read a few of my op-eds if you don’t have time to read the book. They are posted at http://www.kotlikoff.net/.  You’ll see that I’m not forcing unlimited liability on anyone or anything. I’m saying that companies that intermediate financially, regardless of whether they call themselves hedge funds, commercial banks, investment banks, insurance companies, private equity companies, credit unions, have to do their intermediation strictly as mutual fund companies if they want to operated with limited liability. Were this law passed, Citigroup would not become a private company with unlimited liability. Instead, it would become a mutual fund company like Fidelity Investments.  

In this regard, it’s worth noting that none of the major mutual fund companies went bust or needed a bailout during the financial crisis. What happened with the Reserve Primary Fund would not happen under Limited Purpose Banking. Only cash mutual funds would be backed to the buck. 

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

Larry: This is not narrow banking. Narrow banking is about 100 percent capital requirements just for demand deposits. So the reference is misleading. Limited Purpose Banking is a very simple proposal that covers the entire financial sector.

Comments (4)

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  1. Tom H. says:

    I liked the idea the first time. And the second time. And the third……

  2. Bruce says:

    Agree with Tom. It’s a sound proposal.

  3. Neil H. says:

    I agree with you and Larry. I think Tyler doesn’t understand this proposal very well.

  4. mkl says:

    Larry, I think Tyler’s point about businesses supplying commercial credit is important. A normal manufacturing company that sells goods on invoice will have, say, 1 months sales outstanding on credit to its customers. Its accounts receivable are a financial asset with credit risk. It’s a large part on a corporate balance sheet but actually the most liquid and lowest risk (as opposed to inventories, plant and equipment). So receivables are typically the first thing a company borrows against, through factoring or secured credit lines.

    Your proposal would seem to require either all (a) all corporates to sell for cash only and have no receivables, (b) have 100% equity capital structures and zero corporate debt, (c) set up unlevered mutual funds and immediately sell all receivavbles to these, or (d) accept unlimited liability.

    All of these seem like an unworkable burden on companies, and would affect all from the corner store to Exxon.