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     Aug 25, 2010
Debtor's prison or credit control
By Hossein Askari and Noureddine Krichene

The severity of the ongoing financial crisis has invoked more debate than the run-of-the-mill financial crisis that seems to occur about once every 10 or so years. The suggested reasons for this financial crisis have been many: deregulation, failed supervision, unsupervised non-bank financial institutions, inadequate capital, an extended episode of low interest rates, excessive risk taking; then there is the emergence of a parallel banking sector (the repo market), financial innovations (derivatives), mark-to-market accounting, financial sector consolidation and the emergence of "too big to fail" financial institutions.

There are the shortcomings of the credit rating agencies and especially the conflict of interest in their operations, excessive

 
assumption of debt and leveraging, increased international capital mobility, and yes, human greed, fraud and Ponzi finance. The list is long and could be lengthened even further.

Depending on which of these reasons one considers the culprit(s), recommendations for reform have also been numerous. But most reforms are little more than a "bandaging" of the current financial system: higher levels of capital, breaking up financial institutions, re-regulation to include all financial institutions, measures to limit risk taking and to increase transparency and more.

But it is difficult to see how any of these changes will eliminate the likelihood of future financial crises. For example, higher capital would reduce bank lending, to create money and to leverage, but there is always the chance that bad loans could still wipe out a bank's capital. And on and on.

The foundational problem is that the conventional banking system is a fractional reserve banking system that is predominantly based on debt financing and, by its structure, creates money, debt and encourages leveraging. The embedded risk of such a system is that its money and debt creation and leveraging could be excessive. Safeguards, such as deposit guarantee schemes, for example, the Federal Deposit Insurance Corporation in the United States, and the classification of some banks as "too big to fail", are the implicit government subsidies that reduce funding cost and create moral hazard, encouraging mispricing and excessive assumption of risk by financial institutions.

Systemic risks inherent in the system, such as the linkages and the interdependencies of institutions as well as the prominence of too large too fail institutions, create financial instability and threaten the entire financial and real economy.

In other words, the financial institutions of today, in particular the commercial banks, create excessive debt. It is this debt that is, in turn, the basis of systemic risk and threatens the financial system. Carmen Reinhart and Kenneth Rogoff have confirmed that in every financial crisis for the last eight centuries and the world over, excessive debt has been the recurring feature. There is only one road to financial stability - adopt policies and practices that eliminate moral hazard and excessive debt creation and leveraging.

One way to ensure the stability of the financial system is to eliminate the type of asset-liability risk that threatens the solvency of all financial institutions, including commercial banks. This requires commercial banks to restrict their activities to two - (i) cash safekeeping, and (ii) investing client money as in a mutual fund. Banks would accept deposits for safekeeping only (as for example in a system with 100% reserve requirement) and charge a fee for providing this service and for check-writing privileges.

In other words, in such a financial system, there would be no debt financing by institutions, only equity financing and risk sharing. Banks would not create money as under a fractional reserve banking system. Financial institutions would be serving their traditional role as intermediaries between savers and investors (affording savers instruments to encourage savings and channeling their savings to the most productive investments) but with no debt on their balance sheets, no leveraging and no predetermined interest rate payments as an obligation.

Proposals along these lines are not new. During the biggest crisis of all, the Great Depression, such an approach was recommended in the "Chicago Plan". This reform plan was formulated in a memorandum written in 1933 by a group of renowned Chicago professors, including Henry Simons, Frank Knight, Aaron Director, Garfield Cox, Lloyd Mints, Henry Schultz, Paul Douglas and A G Hart, and was forcefully advocated and supported by the noted Yale University professor Irving Fisher.

Noting the fundamental monetary cause underlying each of the severe financial crises in 1837, 1873, 1907 and 1929-1934, the Chicago Plan called for a full monopoly for the government in the issuance of currency and forbidding banks from creating any money or near money by establishing 100% reserves against checking deposits. Investment banks that play the role of brokers between savers and borrowers were to undertake financial intermediation.

Hence, the inverted credit pyramid, the high leveraged financial schemes (eg, hedge funds), and monetization of credit instruments (eg, securitization) are excluded. The credit multiplier is far smaller and is determined by the savings ratio instead of the reserves ratio.

More recent than the Chicago Plan, Laurence Kotlikoff in a book published in 2010 has made a proposal along similar lines, coining it "Limited Purpose Banking" (LPB). Henry and Kotlikoff, writing in Forbes, said of this approach: "Were we really serious about fixing our financial system, there's a very simple alternative - Limited Purpose Banking. LPB would transform all financial intermediaries with limited liability into mutual fund companies. Under LPB a single regulatory agency - the 'Federal Financial Authority' - would organize the independent rating, verification, custody and full disclosure of all securities held by the mutual funds. Voila, by dint of competition and transparency, 'liar loans', off-balance sheet gimmickry, and toxic assets would all disappear. LPB would let the financial sector do only what Main Street needs it to do - connect lenders to borrowers and savers to investors. The financial sector's job is not to take taxpayers to the casino and collect the winnings."

There are many reasons why reform along this, or similar lines, has not entered the political and financial mainstream until the recent financial turmoil. For starters, there is the opposition of the powerful financial sector. The lobbying of the financial sector against fundamental financial reform in the United States is well documented and its interest is evident. Starting in the 1970s, the financial sector has now gained relative to the real sector, as measured by its growing share of gross domestic product, aggregate corporate profits and salaries and bonuses. The financial sector will not readily give up activities and instruments that have allowed it to establish such a dominant position and to accumulate such gains.

A second popular concern is the "assumed" impact on economic growth and prosperity if debt financing is significantly reduced or eliminated. Although most observers attribute a significant role to the explosion of debt and leveraging in bringing about financial crises, at the same time some argue that the reduction, let alone elimination, of debt financing and bank money creation would reduce economic growth.

This is an empirical issue that deserves careful estimation - how would growth over the long haul compare under each regime? And what would be the attendant social benefits and costs under each regime? While many have prejudged the result, we are not sure that booms and busts are superior to steady growth.

A third reason for inaction on fundamental reform is that politicians are by nature and temperament "incrementalists", always with an eye on the next election. Given the lobbying of the financial sector, politicians invariably put off wholesale and fundamental reforms until they have no other option.

Henry and Kotlikoff (2010) judge the recently adopted Dodd-Frank Bill and provide their reason why fundamental reform may have been sidestepped yet again: "This kind of 'cowboy capitalism' is far too dangerous to maintain. But Dodd-Frank does precisely this, albeit with many more regulatory cops on the beat. In contrast, LPB would put an end to Wall Street's gambling with taxpayer chips. Since mutual funds are, in effect, small banks with 100% capital requirements in all circumstances, they can never fail. Neither can their holding companies.

"Under LPB, financial crises and the massive damage they inflict on the entire (global) economy would become a thing of the past. Of course, there would be losers. Some Wall Street executives might have to find employment in Las Vegas or offshore banks. Some lobbyists, lawyers, credit analysts and accountants might need to find higher callings. Some politicians might even have to solicit more support from Main Street. Alas, Dodd-Frank bears no resemblance to Limited Purpose Banking. But bad laws don't always last, and this one may eventually lead us to LPB by showing us precisely what not to do - if we ever get another chance."

While the Chicago Plan or LPB are two approaches to alleviate financial booms and busts, Islamic teachings long ago recommended a similar financial system, incorporating equity financing (risk sharing) and prohibiting debt financing, its attendant interest payments and the risks that accompany excessive debt creation and leveraging; in other words a two-tiered banking system, one that handles deposits for safekeeping only and the other that acts much like an investment bank.

These investment banks invest directly in real projects with investor capital as well as with their own capital, and share directly in the risks of the project. They invest directly in every segment of the economy (except activities that are prohibited, such as gambling and alcohol).

Call reform along these lines whatever you wish as the name is unimportant. But what is important and undeniable is that effective reform must limit debt creation. Otherwise, recurring episodes of excessive debt creation will put countries in debtors' prison with no possibility of avoiding financial and economic crises that keep on coming with regular frequency.

Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.

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