Let's overhaul the financial system

If Dodd-Frank is more of the same, let's change it!

Work with me on this. It’s a bit theoretical, but the purpose is to stimulate ideas for reforming the financial system. Much of the new regulation since 2008 is really just “more of the same” – more rules, more regulation, and more capital, which really amounts to a band aid patch job on the financial system. There are very complex problems and we need simple, “out of the box” solutions.

1. GSEs

Though you would think that Dodd-Frank changed everything, it didn’t address the Government Sponsored Enterprises (GSEs), like Fannie Mae and Freddie Mac. The GSEs have long enjoyed quasi-government status, allowing stockholders to enjoy the benefits of monopoly power, yet be bailed out when they fail. Remember, Fannie Mae and Freddie Mac collapsed just weeks before Lehman in September 2008, so there’s a lingering issue about what to do with them. Currently, there’s a bill floating around Congress to combine them and partially privatize them. It’s a good step forward, but not a full solution. Here’s my solution:

The new GSE (formerly Fannie Mae, Freddie Mac, Ginnie Mae, FHLB, SIPIC, and the FDIC combined) will remain government owned, but cannot leverage itself beyond its deposit base. That is, it can only make as many mortgage loans as its deposit base can support. Where will deposits for the GSE come from? The Post Office.

Post office branches would collect and maintain savings and checking accounts, giving them a new business line. The Post Office will lose all government subsidiaries, relying instead on collecting deposits to plug revenue holes, and most importantly, it will become the only place for government insured deposits.

This will limit GSE competition with the private sector and it means the new GSE cannot become over-leveraged and cannot again collapse like in September 2008.

2. Banks

Now the question is how to solve the “too big to fail,” “too big to prosecute,” and therefore “too big to succeed” issue for the banks. In reality, today’s banking system was created 100 years ago with the establishment of the Federal Reserve in 1913 and reformed twice in 1933 and 1934. The entire banking system and regulation is outdated and based on an old banking model. It needs a complete reform, so here’s a start:

  • U.S. banks would be free to collect deposits from the public, but with the complete understanding that the deposits are no longer government guaranteed. You go to the Post Office for that
  • Banks, broker-dealers, Futures Commission Merchants (FCMs) can buy insurance from the GSE if they want, but it will come at a price and with increased regulation.
  • Financial institutions without a government guarantee or support will enjoy far lighter regulation.
  • All transactions booked on an exchange or CCP receive much lower regulatory capital charges.
  • Banks which operate within multiple financial arenas, like banking, investment banking, asset management, insurance, futures, will be required to hold more capital. The more interconnected they are in the financial system, the more there needs to be a larger capital cushion. But just because an institution is large, doesn’t mean it needs to be regulated out of profitability. 

3. Shadow Banking

The idea of eliminating “overnight” Repo funding gets discussed often. Theoretically, it would make a financial institution more stable, so yes, the idea is good in theory. However, picture a traditional bank 100 years ago and suggest they stop taking deposits that can be withdrawn at anytime – the equivalent of “overnight” funding. It’s the same principle today for overnight Repo funding because bank deposits are effectively the same thing. Back a hundred years ago, if a bank asked depositors for a one month notice period before withdrawing their cash, the bank wouldn’t attract any deposits and would be out of business.

Today, banks provide funding for broker-dealers, FCMs, ABCP conduits, mortgage lenders, and hedge funds during stable economic times, but often pull that funding during any sign of trouble. Just witness how MF Global collapsed after their clearing banks and CCPs pried additional margin from them.

In 1913, the solution for supporting the banking system during a financial crisis was the Federal Reserve system. It functions as a back-up funding facility to provide liquidity to the banking system during bank runs (see my history of CCPs). The Fed was made for the banking industry of the early 20th century, but not for the Shadow Banking industry that developed in the past 40 years. The Federal Reserve system worked great for years, but now there’s a large and significant fundamental problem in our financial system:  there’s no back-up funding for Shadow Banking. So here’s what’s needed:

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