26 October 2012

Laurence J Kotlikof: The Vickers Commission's failure

This column argues that the UK's Independent Commission on Banking has failed in its aims to make banking safer and to change both the structure and regulation of banking as needed. It instead proposes a new way to make the financial system and wider economy safer: Limited Purpose Banking.

The Vickers Commission’s dereliction of duty

Millions of UK workers and retirees who’ve lost their jobs, life savings or both can attest to the terrible havoc traditional banking can wreak on people's lives. Yet financial business as usual, albeit with new cosmetics, is the Commission’s answer. Apparently, the UK banks are not only too big to fail. They are also too big to cross.

The Vickers Commission was charged with keeping the UK economy safe from another major failure of its banking. Unfortunately, it’s done nothing of the kind. Instead, the Commission, whose recommendations the UK government is eagerly adopting, plays lip service to real reform. Worse yet, its proposals may make UK banking riskier than ever.

The Commission’s proposals are a full employment act for regulators and a nightmare in the making for bankers. A banking system that was terribly risky will, on balance, end up riskier, a regulatory system that was dysfunctional will now have many more things to get wrong, and a population that was praying for a sure economic future will be left where the Commission found it – on its knees.

The solution: Limited Purpose Banking

Fortunately, there is a bold, meaningful reform to fix Lombard Street. But it’s one the Commission essentially ignored, notwithstanding its strong endorsement by a very long list of leading policymakers, economists, and financial experts. The reform is called Limited Purpose Banking (LPB). It replaces ‘trust me’ banking with ‘show me’ banking:

• LPB bans all limited liability financial companies from marketing anything but mutual funds. Mutual funds, whether open end or closed end, are not allowed to borrow, explicitly or implicitly, and, thus, can never fail.
• LPB uses cash mutual funds (replacing retail deposit accounts), which are permitted to hold only cash (currency), for the payment system. Cash mutual funds are backed pound for pound by cash in the vaults and none of this cash is ever lent out.
• LPB uses tontine-type mutual funds to allocate idiosyncratic risk, be it mortality risk, longevity risk or commercial risk. And LPB uses parimutuel mutual funds to allocate aggregate risk. Its fully collateralised betting provides a completely safe way to provide credit default swaps, options, and other derivatives.
• LPB mandates full and real-time disclosure. It empowers the Financial Services Authority to hire private companies working only for it to verify, appraise, rate and disclose, in real time, all securities held by mutual funds.
• LPB requires mutual funds to buy and sell their securities in public auction markets to ensure the public gets the best price for its paper.

LPB’s cash mutual funds would provide a perfectly safe payment system. These cash mutual funds would be the only mutual funds backed to the pound. All other mutual funds, be they closed- or open-end, would fluctuate in price. Since the mutual funds under LPB hold no debt, neither they individually nor the financial system in its entirety can fail. Large private losses could still take place within the financial system, but without endangering the rest of the economy or making claims on taxpayers.

Full article

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