Limited Purpose Banking

A Financial System that Can't Fail

Our financial system failed in 2008. Fifteen years later, it has failed again. Over half of FDIC insured banks are now insolvent when properly valued on a mark-to-mark basis. All the King’s horses (the Treasury, the Federal Reserve, and the FDIC) and all the King’s men (the large, systemically important money center banks) can’t put this Humpty Dumpty back together again.

Every financial crisis has its own triggers. But the underlying ingredients, leverage and opacity, are always the same. In this case, the leverage is the $8 trillion in uninsured deposits that U.S. banks have borrowed combined with massive balance sheet opacity sanctioned by government “regulators,” that’s left some $2 trillion of marked-to-market losses off the books. Leverage and opacity are doing their number across the pond. Switzerland is the land of venerable, trustworthy banks. But its second largest bank — Credit Swiss, just went poof thanks to its global depositors realizing not a single Swiss franc of their deposits was insured and that the 156 year-old bank had “some” accounting irregularities.

No one, be they rich or poor, is in love with their bank. They are parking money there to facilitate transactions, including future investing, or simply to keep it safe. They didn’t choose to park their money for the opportunity to have it disappear because of a run based on problems with the bank’s assets of which they were totally unaware because of a tweet, potentially fired off by a party with a short position, produced a panicked run — no different from someone screaming FIRE! in a crowded, dark theatre.

The Great Financial Crisis primarily entailed banks running on banks. The current crisis is more typical - people and businesses, large and small, running on banks. In large part, this run entails those with the $8 trillion in uninsured deposits moving their money to 100 percent equity-financed mutual funds — mutual funds that primarily hold U.S. Treasuries. Since such mutual funds have no debt (They hand back shares, not “for-sure” I.O.U.s to investors.), they can’t fail.

This is an endogenous movement to Limited Purpose Banking (LPB), the perfectly safe, modern banking system I proposed in my 2010 book, Jimmy Stewart Is Dead. The reform eliminates the evil twins — leverage and opacity — that banks, broadly defined, use to play Heads I win, tails the taxpayer loses.

Limited Purpose Banking limits banks and all other financial corporations to their legitimate purpose — financial intermediation. It does so by eliminating all use of leverage by those running our financial exchange system, which connects lenders to borrowers and savers to investors. And it turns on the lights so that everyone can learn, in real time, everything there is to know about the assets in which they’ve invested. This information collection and dissemination would be done by a new federal agency, not Wall Street firms who have repeatedly dissembled about the value and risk of their assets.

Limited Purpose Banking received considerable attention during and after the Great Recession. Mervin King, then Governor of the Bank of England, arranged for me to present the plan at a conference on LPB at the BoE. Some 70 staff from the Bank, H.M. Treasury, and the former Financial Services Authority as well as top private-sector banking and financial experts, including prominent academics, attended. This as well as many other meetings with central bankers and media interviews made clear, LPB is a serious alternative to our built-to-fail current banking system that serious people are taking seriously.

Unfortunately, interest in LPB died down as the titans of Wall Street and The City “arranged” for their paid minions — the politicians — to let them continue to do what they do best — gamble with other people’s money and the health of our economy.

Now that the banking system is failing yet again, LPB is being reconsidered. The Financial Times’ chief financial columnist, Martin Wolf, just mentioned LPB in the FT. And the New York Time’s brilliant economics columnist, Peter Coy, discussed LPB in today’s column.

What, Specifically, Is Limited Purpose Banking?

Below, I reproduce, verbatim, a description of LPB from a book entitled On the Economic Consequences of the Vickers Commission. You can download it for free here.

The Vickers Commission was established to recommend reforms to British banking after the Great Recession. As you can read, it did nothing of the sort. Neither, for that matter, did the heralded Dodd-Frank reform here in the U.S. We’re seeing in real time just how poorly Dodd-Frank works when push comes to shove.

LPB Details

LPB is a simple reform that can be easily implemented. But those who love a good financial crisis will be disappointed. The one thing it doesn’t feature is bank runs, where the word “bank,” as used below references any and every type of financial corporation.

The reason is that under LPB all financial corporations, be they banks, insurance companies, credit unions, investment banks, private equity funds, etc., can do only one thing — issue 100 percent equity-financed mutual funds. This renders the entire financial system fail proof.

The reform was effectively tested in the Great Recession. At the time, there were some 8,000 equity-financed mutual funds. Not a single one failed. The only mutual funds that failed were money market funds that were leveraged via their pledge to back investors to the buck — a promise they broke. Had the Treasury not immediately insured all money market funds to the buck, they would all likely have collapsed in a massive run.

In the Great Recession, we had a financial tsunami. Roughly 60 percent of the houses were built of straw. The other 40 percent were built of brick. Those built of straw collapsed. Those built of brick survived. Senator Dodd and Congressman Barney Frank combined forces to enact Dodd-Frank — a new regulatory framework to end financial crises once and for all. What it really constituted was a restoration of the financial system pretty much as it was. No surprise. Wall Street pays a pretty penny to members of the House Financial Service Committee, the Senate Finance Committee, and the Senate Banking Commission to ensure it can continue to con the American taxpayer.

Banking has always been built to fail. Indeed, it fails every 15 years on average. It failed spectacularly in the Great Recession. Dodd and Frank then ran to the rescue. They and their colleagues, knowing who really butters their bread, rebuilt the system with only minor tweaks. Thus the banking system failed, was “rebuilt” to fail again, and, right on time — 15 years later — is failing again. As for Dodd and Frank, Dodd retired to work for the motion picture industry. Frank retired to work for Signature Bank — the selfsame Signature Bank that just went caput, constituting the 3rd largest bank failure in our country’s history.

Limited Purpose Banking’s Principles

1. The financial system’s role is intermediation, not gambling.

2. The financial system should be transparent and provide full disclosure.

3. The financial system should never collapse or put the economy at risk.

4. The financial system should not require government guarantees and threaten taxpayers.

5. The financial system should be sufficiently well structured as to require limited regulation.

6. The financial system’s intermediation practices should enhance economic performance.

Limited Purpose Banking’s Design

1. All financial corporations can market just one thing – mutual funds.

2. Mutual funds can’t borrow, explicitly or implicitly, and, thus, can never fail.

3. Cash mutual funds, holding only cash, are used for the payment system.

4. Cash mutual funds are the only mutual funds backed to the buck.

5. Tontine-­‐type mutual funds are used to allocate idiosyncratic risk.

6. Parimutuel mutual funds are used to allocate aggregate risk.

7. The  Financial  Services  Authority  (FSA)  hires  private  companies  working  only  for  it  to  verify, appraise, rate, custody and disclose, in real time, all securities held by mutual funds.

8. Mutual funds buy and sell FSA-­‐processed and disclosed securities at auction. This ensures that issuers of securities, be they households or firms, receive the highest price for their paper.

Limited Purpose Banking’s Line in the Sand

Limited  Purpose  Banking  (LPB)  draws  its  line  in  the  sand  not  between  commercial  and  investment banks or between banks and non-­‐banks, but between financial intermediaries with and  without  limited  liability.    All  banks,  insurance  carriers,  hedge  funds,  and  other  financial  intermediaries with limited liability (i.e., all financial corporations) are LPB banks, and all LPB banks would operate strictly  as  unleveraged  mutual  fund  holding  companies;  i.e.  they  would  not  be  permitted to borrow, including going short, to invest in risky assets. Their only permitted function would be to market 100 per cent equity-­‐financed mutual funds.

To ensure LPB banks operate on a completely risk-­‐free basis, their investment banking activities would be run strictly as consulting services and leave the banks with no skin in the game. And all brokerage activities would be done via matching of buyers and sellers of securities, with no exposure of any kind at any time.

Note that the mutual funds marketed by mutual fund holding LPB companies, are, themselves, small  banks  with  100  per  cent  capital  requirements  in  all  circumstances –  what  economists  call  states of nature. Hence, under LPB neither the mutual funds themselves, nor their holding companies, the LPB banks, could ever go bankrupt. Some reformers advocate breaking up large banks. LPB effectively does this. It morphs large banks into large mutual fund holding companies that operate large numbers of completely safe (in the sense that they themselves can’t fail) small banks called mutual funds. These mutual funds would be both open and closed-­‐end, with in-­‐kind redemption rules governing open-­‐end funds to preclude any question of payout in the case of significant simultaneous redemptions.

LPB — The Role of Financial Regulation

Because every financial corporation would be a mutual fund holding company marketing non-­‐leveraged mutual funds that could never go broke, financial collapse would be a thing of the past.  So  would  non-­‐disclosure,  insider-­‐rating,  and  the  production  of  fraudulent  securities.  A  single regulatory body — the Financial Services Authority (FSA) — would hire companies, which work exclusively for the FSA, to verify and disclose, in real time, all details of all securities being bought, sold, or held by the mutual funds.

Take mortgages. The FSA would verify the employment status, current and past earnings, credit history, and credit  rating  of  the  mortgage  applicant. The  companies  working  for  the  FSA  would  also  appraise the value of the house the applicant seeks to purchase. Most importantly, it would disclose  all  details  about  the  security  on  the  web  at  the  time  it  is  issued  and  on  an on-­‐going  basis until the mortgage is paid off.

Issuers  of  the  security  would  be  free  to  post  their  own  assessments  of  the  paper  they  are  issuing, including private ratings that they have purchased. But the public would no longer need to trust people and institutions that have proven they aren’t trustworthy. This would put an end to the liar loans, NINJA loans, and No-Doc loans that were issued and quickly resold by “trustworthy” lenders during the run up to the Great Recession.

The LPB Auction Market

Once a new security is initiated by an LPB bank, processed by the FSA, and fully disclosed on the web, it would be put up for auction to the mutual funds being run by the LPB banks. This would ensure that issuers of bonds and stock receive the highest prices (pay the lowest interest rates) for their securities.

The  FSA’s  role  may  sound  like  lots  of  state  intervention  in  the  financial  marketplace. It’s  actually the opposite. The remit of the FSA would be very narrow. And most of its work would  be  done  by  the  private  sector  –  by  private,  non-­‐conflicted,  third-­‐party  appraisers  and  risk raters hired by the government.

The FSA will not ban any securities. It will disclose them. By analogy, the FSA will ensure that a bottle with cyanide is labelled cyanide, not Tylenol, so that people who shop in financial stores (mutual funds) will know what they are buying.

We  know  from  long  experience  that  markets  don’t  work  without  well-­‐enforced  rules  of  law.  The FSA sets financial rules of law, namely, that you can’t sell what you don’t have. But it doesn’t say what financial products can or can’t be sold.

 The  market  will  no  longer  be  forced  to  rely  on  ‘trustworthy’  bankers  to  honestly  initiate  securities, whether they be mortgages, consumer loans, small-­‐business loans, large corporate debt issues, or equity offered by small or large businesses.

Wouldn’t LPB restrict credit?

No. Under LPB, people who seek to lend money to home buyers would simply purchase shares in a mutual fund investing in mortgages, with the money going directly to the mutual fund (not to  the  bank  sponsoring  the  fund)  and  from  there  to  the  home  buyer  in  return  for  his  or  her paper (mortgage). Those wanting to lend to small (large) companies would buy mutual funds investing in small firm (large firm) commercial paper. Those wishing to finance credit card balances would buy mutual funds investing in those assets.

Credit  is  ultimately  supplied  by  people,  not  some  magical  financial  machine.    And  every  dollar people want to lend would be provided to borrowers via mutual funds or in direct person-­‐to-­‐person loans or via non-­‐LPB banks that are not protected by limited liability.

Limited Purpose Banking is extremely safe compared to our extremely risky and, indeed, radical status quo. Indeed, it’s hard to think of LPB as being anything but highly conservative in terms of  maintaining  the  safety  of  the  financial  system,  requiring  disclosure  to  preclude  fraud  in  financial markets, and keeping bankers from imposing unaffordable costs on taxpayers.

Furthermore,  LPB  is,  in  large  part,  already  in  place,  at  least  in  the  US.  The  US  mutual  fund  industry now has over 7000 individual mutual funds that collectively hold over one third of US financial assets. The number of mutual funds is almost twice the number of FDIC-insured banks, and most Americans do most of their banking through mutual funds. How so? Mutual funds are the principal repositories of their 401(k), IRA, and other tax-­‐favored retirement accounts. A sizable share of these 10,000 mutual funds is involved in credit provision. And roughly half of mutual fund assets are credit instruments.

Another  example  of  the  use  of  mutual  funds  to  provide  credit,  specifically  mortgages,  is  the  covered-­‐bond markets of Denmark, Sweden, and Germany. The covered bonds are offered by banks through what looks, to a very large degree, like mutual funds. Indeed, if the banks selling covered  bonds  were  precluded  from  insuring  bondholders  against  default  risk,  the  covered  bond markets in Europe would simply constitute LPB mortgage mutual funds.

Moreover,  large  borrowers  have  been  voluntarily  bypassing  the  banks  over  the  last  quarter-­‐century, and borrowing most of what they need from the capital markets. In other words, they are already getting most of their credit from the kinds of mutual funds that LPB would expand.

Using Cash Mutual Funds for the Payment System

Under LPB, cash mutual funds would be used for the payment system. Cash mutual funds hold only  cash, which is placed in reserve with the Federal Reserve,  pay  no  interest,  and  never  break  the  buck.  They  are  the  only  mutual funds that don’t break the buck, for the simple reason that, apart from the fees charged for  holding  investors’  cash,  there  is  always  one  dollar for  every  dollar  invested. 

If  a  Reserve  Primary  Fund  (the  huge  money  market  fund  that  went  under  in  2008)  wants  to  purchase ‘safe’ securities, like AAA-­‐rated Lehman Brothers bonds, that fact will be disclosed in broad daylight on the web. So no one can claim they didn’t know what was being done with their money. Such money market funds would be marked to market on a continual basis, and the mutual fund holding company sponsoring the mutual fund would be precluded from using any of its assets to support the buck of any mutual fund. Hence, from day 1 of the introduction of LPB, some money market mutual funds will break the buck and the public will get used to that happening.

Holders of cash mutual funds would access their dollars at ATMs, via writing checks, or by using debit cards. Thus, cash funds represent the checking accounts of the new financial system and are used for the payment system. This is the ‘Narrow Banking’ component of Limited Purpose Banking. But as is clear, LPB goes far beyond Narrow Banking. It doesn’t simply keep the payment system perfectly safe. It keeps the entire financial system perfectly safe.

Idiosyncratic Insurance Mutual Funds

The mutual funds that insurers would issue would differ from conventional mutual funds. First, purchasers  of  such  insurance  mutual  funds  would  collect  payment  contingent  on  either  personal outcomes or economy-­‐wide conditions or, potentially, both.

This  lets  people  buying  an  insurance  mutual  fund  share  risk  with  one  another.  Second,  they  would be closed-­‐end mutual funds, with no new issues (claims to the fund) to be sold once the fund had launched.

Take, for example, a three-­‐month, closed-­‐end, life insurance fund sold to healthy males aged 50 to  60.    Purchasers  of  this  fund  would  buy  their  shares  on,  say,  January  1,  2011,  and  all  the  monies received would be invested in three-­‐month Treasury bills. On April 1, 2011 the pot, less the fee paid to the mutual fund, would be divided among those who had died (their estates) over the three months in proportion to how much they contributed.

Hence, Limited Purpose Banking permits people to buy as much insurance coverage as they'd like. The most important feature, though, is that these insurance mutual funds pay off based not just on diversifiable risk, but also based on aggregate risk. That is, if more people die than expected, less is paid out per decedent.29

For students of financial history, this is simply a tontine, a financial security that dates to 1653. Tontines were an everyday financial institution for over two centuries. The French and British governments raised money by issuing tontines. The New York Stock Exchange first met under the buttonwood tree, but its members quickly moved into a drier, warmer space, named the Tontine Coffee House.

Tontines  were  paid  off  to  shareholders  if  they  lived,  not  if  they  died.    But  the  payoff  can  be  predicated on death or any other idiosyncratic risk, including property losses, disability, medical costs, accidents, etc.

In all cases, the fund’s pot is given and is paid out to the ‘winners’ (those suffering a loss). Since these are fully collateralised bets, there is no liability visited upon unsuspecting taxpayers. The pot of this and all other LPB mutual funds constitute natural financial firewalls – something that is desperately needed and entirely missing from our current financial system.

To repeat, if and when a virulent form of Swine Flu really hits, our current financial system is set up to ensure not just widespread human death, but also widespread financial death. LPB is set up to ensure the financial system is unaffected.

Parimutuel Insurance Mutual Funds

The  final  point  is  that  insurance  mutual  funds  can  be  set  up  to  bet  exclusively  on  aggregate  outcomes, like a particular company going bankrupt or the nation's mortality rate exceeding a given level. Shareholders in such closed-­‐end funds would specify whether they were betting on the event occurring or not. If the event occurs, those betting on the occurrence take the pot (the  holdings  of  the  mutual  fund  less  the  fee  charge  by  the  mutual  fund  managers)  in  proportion to their shares. If the event doesn't occur, those betting against the occurrence take the pot based on their shares.

If bets like this on non-­‐personal outcomes sound familiar, there’s a reason. This is simply pari-­‐mutuel betting, which has been safely used at racetracks around the world since 1867. There is no recorded instance in which a bet on a horse at any racetrack ever cost taxpayers a single penny.

Let’s consider some examples of LPB pari-­‐mutuel funds. Suppose the elderly want to bet with the young on whether mortality exceeds a given rate. The elderly would bet on low mortality, because if mortality is low their longevity (annuity) tontines would pay less. The young would bet on high mortality, because if mortality is high, their life insurance tontines would pay less. So each side hedges the other. This is allocating aggregate risk, which a proper financial system needs to do. It is not insuring against aggregate risk, which no financial system can do.

What about modern financial instruments like CDS and options? Do they disappear? Not at all. LPB combines modern and ancient finance. A closed-­‐end parimutuel fund that entertains bets on a company’s stock exceeding a given price on a fixed date is just an option. A credit default swap (CDS) is a parimutuel fund that stages bets on a company’s defaulting on its bonds over a fixed  period  of  time.   A collateralised  debt  obligation  (CDO)  is  a  mutual  fund  that  invests  in  particular types of loans and pays out the pot to shareholders based on pre-­‐specified sharing rules. These clear sharing rules allow the different parties to take more or less leverage vis-­‐à-­‐vis each other, but they preclude leveraging the fund and, thus, the taxpayer.

LPB can thus provide the economy with as much legitimate leveraging as the population desires. This leveraging can, as just indicated, occur within mutual funds, or by mutual funds buying up the  mortgages,  notes,  bonds,  and  other  debts  of  households,  small  and  medium-­‐sized  proprietorships and partnerships and corporations.

Under LPB, insurance mutual funds always involve fully collateralized bets. I.e. all the money in play is on the table, not in some banker’s imagination or in the pockets of taxpayers who need to bail out an AIG after selling nuclear economic war insurance in the form of unbacked CDSs.

Democratising and Modernizing Finance

LPB  takes  control  of  finance  away  from  large,  secretive,  unaccountable  banks,  insurance  companies, and other financial corporations and puts it in the hands of individuals via their mutual fund investments. Individuals who are very risk averse will buy shares of mutual funds that  invest  in  shorter-­‐term,  safer  assets.    Individuals  who  are  less  risk  averse  will  invest  in  mutual funds that hold riskier assets. Unlike the current system, the public will have a much better understanding of the risks they are accepting. And, most importantly, the public will no longer be exposed to the risk of losing their jobs and their lifetime savings through man-­‐made financial system collapse.

Implementing  LPB  would  be  much  more  difficult  without  the  internet,  which  would  be  used, not only as it is today, to manage mutual fund investments, holdings, and withdrawals, but also to disclose, in real time, mutual fund securities and to run the mutual fund securities auctions.

To some, the idea that traditional banking would disappear seems incredible. But the history of human progress is one incredible story after another. Traditional farming, traditional retailing, traditional  horse  and  buggy  transportation,  traditional  media,  traditional  everything  has  and  will change.

The  main  reason  we  are  still  inflicted  with  a  millennia-­‐old  financial  system  that  has  failed  repeatedly through the ages is that traditional banking is being implicitly subsidized by governments,  or  rather  politicians  who  are  willing  to  bail  out  the  banks  when  they  get  into  trouble. This financial guarantee is not simply motivated by public interest. The financial sector is  well  adept  at  influencing  the  politicians  through  campaign  donations  and  promises  of  very  high-­‐paying jobs once they leave office. Just check the principal contributors to the members of the House Financial Services Committee.

The  introduction  of  parimutuel  funds  could  bring  forth  much  of  the  financial  innovation  that economics Nobel Laureate, Robert Shiller, and many others have been so passionately advocating. We should, for example, be able to bet with people from other countries that our economy will do poorly and theirs will do well. This will hedge us against the risk of recession. Such risk sharing would, under LPB, be run through a pari-­‐mutuel fund where the bet is on US GDP growing, say, more or less than 3.5 per cent.

In  general,  there  is  nothing  in  Limited  Purpose  Banking  that  limits  legitimate  financial  innovation. But illegitimate, highly leveraged, financial ‘innovation’, involving the sale of undisclosed snake oil, will be precluded.

Assuaging Concerns about Limited Purpose Banking

LPB doesn’t limit borrowing by firms or households. Indeed, thanks to the FSA’s services and the auction mechanism, it should enhance their ability to borrow as well as sell equity. This is particularly true of small and medium-­‐sized enterprises.

LPB  eliminates  leverage  by  financial  intermediaries,  where  leverage  entails  great  macroeconomic risk. The fabled Modigliani-­‐Miller Theorem in finance tells us that leverage doesn’t matter unless there are bankruptcy or information costs, in which case equity is preferred. In banking, bankruptcy costs are arguably as high as it gets, and the FSA is designed to dramatically reduce information costs.

In  eliminating  bank  leverage,  LPB  eliminates  the  leverage  intermediaries  have  over  taxpayers  during a financial crisis in credibly threatening financial meltdown if they aren’t bailed out. Eliminating fractional reserve banking will make the money multiplier 1, but it won’t reduce the money supply since the Fed can increase the monetary base, which will equal M1, as it sees fit.

Demand  deposit  contracts  are  not  essential  to  maturity  transformation,  which  is  code  for  liquidity risk sharing. Charles Jacklin and others have shown that trading in securities can substitute  for  demand  deposits.    Demand  deposit  contracts  may  have  some  liquidity  risk-­‐sharing advantages depending on their construction in certain settings and circumstances compared  to  market-­‐based  insurance,  but  improving  liquidity  risk  sharing  in  good  equilibria  appears to be very highly overrated relative to eliminating the risk of bad equilibria caused by runs.

The use of debt contracts to indirectly discipline bankers who can’t be monitored presupposes the  bankers  are  bank  owners,  which  is  hardly  the  case,  and  that  what  bankers  do  can’t  be  disclosed, and thus monitored, which it can be via the FSA.

LPB  mutual  funds  would  include  credit  card  debt  and  other  lines  of  credit,  whether  to  households or firms. But these lines of credit would be fully funded. I.e. the mutual fund’s unused lines of credit would be backed to the buck by cash holdings of the mutual fund offering the credit lines.

The  FSA’s  disclosure  of  household  mortgages  and  other  debt  securities  would  not  reveal  the  identity of the household. For example, in the case of mortgages, the location of the house being mortgaged could be specified within a mile of its actual location, with no mention made of the borrower’s name or specific employer. For households who are particularly concerned about  their  privacy  being  violated,  there  is  an  alternative  available  under  LPB,  namely  to  borrow from unlimited liability banks.

The FSA’s disclosure of each security would include evaluations of the security’s complexity and payoffs,  both  known  and  unknown,  in  specific  states  of  the  world.  More  complex  securities  with less well understood payoffs would be disclosed as such and, presumably, command a lower price when put up for auction. This would be for the good. Highly complex securities whose payoffs aren’t well understood are like bottles of Tylenol, but with extra pills included of unknown medicinal value. Such bottles needed to be properly labelled as ‘pills with unknown properties’ so that people that aren’t interested in random ‘medical’ treatments aren’t induced to buy what they don’t want.

In  short,  less  may  be  much  better  than  more  when  it  comes  to  the  number  of  complex  securities initiated in the market place. With fewer, uniform, well-­‐understood and fully disclosed  securities,  the  job  of  the  FSA  will  be  much  easier  than  it  might  seem.    Also,  it’s  important to bear in mind that information dissemination is free once that information is acquired. Hence, having the FSA evaluate and publicly disclose securities obviates the need for financial  companies  (each  mutual  fund  in  the  case  of  LPB)  to  engage  in  so  much  duplicative  security analysis. I.e., the FSA will provide a critical public good — information.

Relationship banking doesn’t disappear. Mutual fund managers will specialize in learning about particular  paper  issuers  prior  to  bidding  on  their  paper  to  the  extent  that  such  knowledge  acquisition has value. Thus, the FSA won’t preclude mutual fund managers from gathering their own private information and reaching their own judgments about the securities they might buy.

Finally, LPB permits unlimited liability banks to operate in the conventional leveraged manner. Hence, if traditional banking holds some hidden magic, unlimited liability banks will be able to capture that value. But if the unlimited liability bankers want to leverage and put the economy at risk, they will do so knowing they may lose everything they own. Switzerland, by the way, has several unlimited liability banks, which operate side-­‐by-­‐side with the country’s large banks. But  this  unlimited  liability  financial  sector  is  quite  small  compared  to  the  limited  liability  financial sector and, interestingly enough, is starting to issue mutual funds to naturally limit the owners’ liability.

Implementing Limited Purpose Banking

Implementing  Limited  Purpose  Banking  is  straightforward.  All  financial  corporations  immediately begin marketing cash, insurance, and other mutual funds and the mutual funds start buying the FSA-­‐processed securities at auction.

Checking  account  holders  would  be  asked  to  sign  an  agreement  transferring  their  checking  account balances to cash mutual fund accounts. The government could provide a financial incentive to do this on a timely basis with all non-­‐transferred checking account balances being remitted to their account owners at, say, the end of a year.

Banks would also offer their other creditors the option to transfer their credits, be they time deposits,  certificates  of  deposits,  or  short,  medium,  and  long-­‐term  bonds  to  mutual  funds  of  similar longevity. Thus holders of time deposits and certificates of deposits would have their holdings of these assets transferred to short-­‐term money market funds, which would purchase the short-­‐term assets held by the bank.

Long-­‐term bank creditors would be incentivized to swap their holdings for shares of mutual funds that specialize in long-­‐term bonds, stocks or real estate. These mutual funds would then purchase these assets from the banks. In the case of real estate, the mutual funds would be closed-­‐end funds, which don’t provide for immediate redemptions, but have shares that trade in secondary markets.

This swap of debt for equity in the banking system could occur gradually over several years. To encourage  the  switch,  the  government  could  also  levy  taxes  on  bank  liabilities  that  have  not  been converted, after a given period of time, to mutual fund equity.

Hence, the transition to LPB is gradual with respect to unwinding existing bank assets and debts, and recycling funds out of banking and into the new, transparent financial system. But the transition is immediate with respect to issuing new mutual funds. Banks become zombies with respect to their old practices, but gazelles in exercising their new limited purpose – being the trustworthy financial intermediaries they claim to be and our country needs them to be.