How to take intellectual hazard out of Ferguson and Kotlikoff December 4, 2009 at 6:00 am
The two first introduce Limited Purpose Banking, or LPB. They then write, in How to take moral hazard out of banking:
Mutual funds are, effectively, small banks, with a 100 per cent capital requirement under all circumstances. Thus, LPB delivers what many advocate – small banks with more capital. Will this work? It has. Unlike so much of the financial system, the mutual fund industry came through this crisis unscathed. True, the Primary Reserve Fund broke the buck by investing in Lehman and had to be bailed out. But under LPB only cash mutual funds (invested solely in cash) would never lose investors’ principal. The first line of all other funds’ prospectuses would state: “This fund is risky and can break the buck.”
(The full FT article is here.)
Um, no. First, mutual funds don’t have a 100% capital requirement: they have a 0% one. All their funding is debt. This makes them highly risk averse: at the first sign of trouble, they sell, exacerbating liquidity problems in the short term note and CP markets. Using short term notes to fund longer term risk taking is a recipe for disaster. Instead we do at least know that historically using insured retail deposits to fund loans is relatively sound, provided that capital requirements are high enough. Splitting originating loans from taking the risk on them doesn’t work as there is no alignment of interests: splitting deposit taking from risk taking doesn’t work either due thanks to mismatch in the term of funding.
Turning now to Felix Salmon, we find:
if investors think that huge losses are coming around the corner, or that a bank is incapable of making sustainable profits over the long term, then no amount of capital today is likely to reassure them that a bank is safe.
This is not true. Some amount of capital will certainly reassure them: an amount equal to the plausible worst case losses, plus a bit, say. OK, that might be quite a bit more than 2% core tier 1 ratio permitted under Basel, but that’s fine.
stock-market investors don’t necessarily reward well-capitalized banks and punish those with only thin layers of equity — in fact the opposite is true much of the time.
Duh, as Homer would say. High leverage = high returns in the good times = high equity price. Of course the equity markets reward high leverage most of the time: most of the time, high leverage is fine. It’s just that when it isn’t, the costs are enormous. No, I wish I had a better recipe than the universal bank under high capital requirements, but I don’t, and I don’t think anyone else has either. Unless of course you know different.