Saturday, October 31, 2009

How About a New Financial Intermediary: Main Street Banks?

The essential function of the banking system is to take money from savers and other holders of capital and lend it to borrowers. Banks serve as intermediaries in this process, taking capital in the form of deposits and deploying it in the form of loans. Without the intermediation of banks, holders of capital would have a harder time obtaining returns and borrowers would have a harder time getting loans. Capital would flow less freely and economic growth would probably be slower. Banking--i.e., the original form of financial intermediation--worked because bankers provided the expertise needed to make sound, profitable loans. Because bankers held the loans, they managed them prudently to minimize loan losses.

A very important innovation in financial intermediation in the last 30 years was securitization of loans. This was a process in which banks bundled together loans into asset backed securities and sold interests in these securities to investors. Through the magic of financial engineering, stodgy residential mortgages, and eventually credit card, auto and commercial loans, often ended up in AAA-rated investments sold on Wall Street. Banks liked securitization because it provided fee income from making and selling loans, and then managing them, while supposedly transferring the risk of credit losses to the investors. Funds obtained from the sale of the loans would be used to make new loans, with more fee income generated. Loan losses would go down because fewer loans would be held. The banks' return on capital presumably could go up as banks became fee earning entities rather than lenders bearing the risk of credit losses. The real lenders, the investors in the securities, were often getting investments that were supposed to be about as safe as U.S. Treasuries.

We know how this story ended. The banks got so good at marketing their financial marvels that everyone and their uncle, including municipalities in Norway, wound up buying America's biggest export: loans. Banks' demand for loans, especially mortgage loans, became voracious and anyone with a pulse and signature could get one. Trillions of dollars were invested in mortgage backed securities and derivatives thereof like the now infamous CDOs. The securitization market became the dominant and unregulated sector of commercial banking. Risk wasn't managed because it supposedly was being dumped on--whoops, transferred to--the investors. Things would have worked out fine if the laws of economics had been suspended and the real estate market had kept rising forever.

But when fantasies collide with reality, it ain't reality that loses. Now, in the aftermath of the mortgage crisis and credit crunch, investors avoid securitizations like the plague, because securitization proved to be a plague on investment portfolios. CPR administered by legions of federal paramedics has raised a faint pulse in the securitization market, but the Fed can't forever continue its role as the buyer of first and last resort in the securitization market. Realistically speaking this patient won't recover. Trillion dollar markets are now billion dollar markets, and that's only for carefully screened bundles of loans to prime borrowers. Subprime loans, to the limited extent they are made at all, couldn't be sold for a nickel.

In spite of trillions of dollars of bailout money, cheap credit and other federal accommodations, the big banks aren't lending. Smaller banks are pulling back, and can be expected to scale lending down even more next year as commercial real estate losses take hold and unemployment rises. The credit crunch isn't over. It's simply shifted from money center banks to consumer and commercial borrowers. In other words, it's gone from Wall Street to Main Street.

New lending is badly needed. Securitization has lost credibility with investors and won't play a major role in the future. A new form of financial intermediation is needed. It shouldn't be complex or novel, because today's holders of capital, afflicted with battered investors syndrome, won't go near anything smacking of financial engineering. Reliability is far better than genius when your retirement money or college fund is at risk. Using familiar, existing structures would be the easiest way to go.

Back in the days when a single black and white TV in the living room and one car in the garage were considered hallmarks of a comfortable middle class life, banks were securitizations. They made a variety of loans, held them in their portfolios (effectively bundling them) and paid depositors interest from the interest paid by borrowers. In effect, the depositors had a de facto interest in the bank's portfolio of loans. Not all banks got AAA ratings, but federal deposit insurance was more than the equivalent so depositors considered their money safe.

A quick way to steer credit back toward Main Street would be to offer regulatory advantages to banks chartered (or rechartered) to lending primarily to Main Street--i.e., to consumers and businesses. For example, let's say we require a bank to lend at least a third of its deposits to consumers, another third to businesses, and a minimum of 90% to consumers and businesses combined (so that if the bank loaned 35% to businesses, it would have to lend at least 55% to consumers). Such a Main Street bank could be allowed to offer federally insured accounts up to $1 million or even $5 million per customer for interest bearing accounts (compared to current limits of $250,000); non-interest bearing accounts today are already insured without limit but that hasn't solved the Main Street credit problem. With heightened federal deposit insurance coverage, Main Street banks could attract larger depositors looking for safety, and the government would funnel more credit to those who today are crunched.

Many of America's smaller financial institutions could probably transform themselves into Main Street banks with relative ease, since they tend engage in traditional commercial banking. Credit unions, in particular, might find Main Street banking familiar. Since federal banking regulators are imposing greater prudence on all banks, raising the insurance deposit limits shouldn't result in a surge of reckless lending. Besides, the fact that there is no securitization market in which to dump dicey loans would make Main Street banks more cautious anyway. The cost to taxpayers of Main Street banking's higher deposit insurance coverage could be ameliorated by the fact that federal deposit insurance is paid for, in the first instance, by premiums charged to the banks. Taxpayers only provide backup. Main Street banks could be required to pay higher premiums for their better coverage.

Of course, it's likely the big money center banks would be vociferously unhappy about any such proposal, since they couldn't transform themselves into Main Street banks. They're too heavily invested in stock and commodities trading, investment banking and other activities that generate very large employee bonuses. But Wall Street's engineers are looking for lucrative ways to buy up whole life policies, not make loans to consumers or to the small businesses that typically do much of the hiring in an economic recovery. The big banks are not serving the public need for credit, and we need someone who will. Chartering Main Street banks may be a quick way to revive lending to the real economy.

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