Wednesday, October 08, 2008

Nationalize Large US Commercial Banks?

My friend B's predictions from 1993 about the shape of banking have finally come true, as I noted in this recent post.

Not only did he correctly prophesy the consolidation of all publicly-held banking into 3 mega-utilities. He also opined that, in time, all of their activities would be so heavily regulated as to make them quasi-governmental entities.

In effect, B believed that the remaining commercial banks would become more tightly-leashed, duller, larger GSEs than the failed Fannie and Freddie.

Edmund Phelps' editorial in a recent edition of the Wall Street Journal contained a clue to this possibility. He argues for direct investment of US Treasury funds in commercial banks, in exchange for warrants.

What if, rather than this temporary investment, the US government simply funded basic consumer banking in this country?

By stripping large US commercial banks of any risk-taking businesses besides heavily quantifiable, easily-regulated activities such as mortgages, small business lending and credit cards- the government would effectively nationalize the basic consumer savings and lending activities of our economy.

Given the turmoil experienced by the financial sector over the past 50 years, this might not be a bad thing. The financial behemoths left standing- Chase, Wells, maybe Citigroup, and BofA- have equity that will most likely perform like a bond anyway. They are too large to consistently create value at an above-average rate.

Rather than allow these giants to be universal banks, including underwriting and securities trading, why not just go the other way, strip them of asset management, underwriting, trading and any esoteric lending businesses that can't be operated by rule-based procedures involving credit scores, down payments, balance sheets, etc?

By removing all scope for innovation in these banks, the bedrock deposit-taking, savings safekeeping and lending functions in America would be insured, protected, and firewalled from any other riskier financial activities.

As we observe Congressional reaction to its own seminal role in the current financial debacle, we can probably expect the same dimwitted approach to re-regulating financial services as we saw to their deregulation a decade ago. It's a fair bet that now Congress will legislate mortgage lending to a point of near-unprofitability. Perfect for a heavily-restricted and regulated financial utility to handle.

With the current Treasury purchases of mortgage-backed securities, including CDOs, you may as well just put the government explicitly in the mortgage lending business. They mandated the lending to poor credit risks that started the current financial situation. Why not just nationalize housing lending for home values below some multiple of the median US home price?

All of the other activities which have led to financial sector troubles- derivatives, swaps, asset-backed securities, trading, 'creative' mortgages, subprime credit cards, and the like- will be prohibited to commercial banks, but allowed for private financial institutions and non-bank, publicly-held entities. But even these latter institutions would have leverage restrictions. Plus, Federal agencies could, by setting down rules for counterparty dealings, limit the shape and leverage of unregulated entities by making them unsuitable counterparties for regulated ones.

I honestly believe we are heading toward this point. With such a major structural change in financial services providers in the past few months, it's clear that these recent events are spurring an oversized backlash. This will probably result in a replacement of Glass-Steagall with some assemblage of rules which will make commercial banking virtually publicly-owned. In order to avoid risky activities, banks which take consumer deposits, do basic secured or credit-score-based lending and transact financial transfers will be effectively government-guaranteed, and perhaps even owned.

This actually isn't such a bad idea, given the gradual concentration of crucial banking functions into so few, publicly-held companies. With such a dearth of diversity among financial institution options now, it may well be prudent for our society to simply nationalize basic banking functions.

Ironically, financial services has, by dint of technology, become so commoditized, yet able to destabilize our economy by taking undue, ill-advised risk, that basic financial services are, truly, a form of 'utility.' Like power and rail transport.

We seem to have arrived at a point where, truthfully, there's not a nickel's worth of difference between the surviving financial juggernauts. Citigroup, Chase, BofA, Wells Fargo- they all do the same core functions in the same way, using similar risk-scoring and processes.

They may as well become federally-guaranteed, heavily-restricted agents of the government, licensed to purvey basic, unspectacular financial services.

In another twist, this will return Glass-Steagall to our country's financial service sector, by simple, draconian government control of basic banking. Anything else will have to be done elsewhere. Probably, again, with heavy regulation, if publicly-held, on leverage, margin positions, and use of exchanges for allowed instruments.

Do I think this would be wise? Yes. And, I think, so does my friend, B, whose idea this originally was.

We've seen that financial institutions, when publicly-held, will test regulatory boundaries and ignore systemic effects of their actions. They are paid to enrich shareholders, not the public at large. So long as innovative, growth-oriented financial services are allowed to be pursued in conjunction with economically-sensitive businesses such as deposits, consumer loans, mortgages, and mutual funds, they will poison the entire system with the risks of their growth-oriented businesses.

And, eventually, as occurred in this latest round of financial mismanagement, they will even throw risk-management to the winds in basic, non-growth businesses like mortgage lending.

The only way to firmly stop this is to completely firewall those core financial functions.

It may take 5 years, or a decade, but we will probably get to that point eventually. And, in light of recent observations on human behavior for profit-making, but less acuity on risk management, in the financial sector, it's almost certainly a good thing.

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