Reforming the Financial System

Larry Kotlikoff and I are proposing Limited Purpose Banking – a top-to-bottom reform of the financial system – including banks, near banks, investment banks, private equity hedge funds, insurance companies, etc. A brief description is at the New Republic web site and a fuller description is at Larry's site.
Here's the idea. No one should be able to put you at risk without your knowledge or consent. Individuals should be free to take any risk they like and our financial institutions should facilitate risk taking. But institutions should not be able to use your funds to make highly leveraged, risky gambles that you know nothing about.  Nor should they be permitted to gamble at the taxpayer's expense.  

The rest is below the fold.

We don't need an FDIC to secure checking account deposits under our proposal.  Nor do we need to leave taxpayers exposed to "too-big-to-fail" bailouts. And we don't need all manner of counterproductive regulations. Instead we need all financial corporations, including all insurance companies, to adopt the pass-through model of asset ownership mutual funds now use. This would allow people to:  

  • Have cash mutual fund checking accounts that are fully backed by cash on hand.
  • Have mutual fund accounts that are fully backed by Treasury bills, thus giving people the security of the full faith and credit of the federal government directly.
  • Hold other kinds of mutual fund accounts with other kinds of risks (e.g., corporate bond funds, stock funds, housing mortgage funds, etc.).
  • Pay insurance premiums to mutual funds which invest in Treasury bills and are exclusively organized to pay off claims with only the premium income they receive.

Limited Purpose Banking requires 100 percent reserves of its checking accounts. This eliminates the need for the FDIC. Financial corporations would neither hold financial assets nor borrow for other than business purposes.  Consequently, they would never engage in risky gambles.  Their mutual funds, on the other hand, could hold all manner of risky securities; but these funds would be owned solely by their customers (the public).  Hence, the public takes risks, not the financial industry, which would be strictly limited to one purpose – financial intermediation, i.e., connecting lenders and savers (who put money in mutual funds in the course of buying mutual fund shares) to borrowers and investors (who take money from mutual funds in return for mortgages, bonds, stock, and other securities).
The role of the government would not be that of regulator. Instead the government would create transparency by rating, verifying, certifying, and disclosing all the financial securities purchased by the mutual funds.  It would not tell anyone how much they can borrow or how much risk they can take.  Under Limited Purpose Banking, individuals would decide what mutual funds to buy, but they would do so knowing, to the maximum extent possible, what it is they are buying. 

Comments (6)

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  1. Tom H. says:

    I like the idea. Especially the part about financial institutions not being able to use my funds as collateral to make risky bets.

  2. Cesar Conda says:

    John – is an excellent idea. I will promote it in my blogs and opeds as well.

  3. Steve Robinson says:

    John –
    I agree our maturity-transforming, fractional-reserve banking system is a problem. But, it seems to me the prevailing “don’t break the buck” mentality suggests most people are so risk averse that they would not accept your mutual fund alternative without a “government guaranteed mutual fund insurance program.” That defeats the purpose, doesn’t it?

  4. John Goodman says:

    Answer to Steve: If people are that risk averse, they can have a cash account. It would work the way mutual funds work today. The account holder would be the sole owner of the cash in the account. There is no need for any FDIC. Of course such an account would pay a negative rate of interest (the warehouse charges for servicing the account).

    People could also have a “checking acount” backed by Treasury bills. This would give them the full faith and credit of the federal government directly, again without any need for an FDIC. Since the value of Treasury bills varies as market conditions change, there would be some modest restrictions on their ability to write checks on such accounts.

  5. John Goodman says:

    Also, see the comments at the New Republic web site here:

  6. William Niskanen says:

    This is the strongest case for broad reform of the financial markets that I have read; congratulations. My own focus has been on the case for restructuring the mortgage market, but you convinced me that a broader reform is more important.