Banking

Small Bank

Banks are useful. They guard money. They record financial transactions. They broker loans between depositors and borrowers. Banks create most of our money supply.

Banks are dangerous. They can fail catastrophically. And when banks fail, thousands or even millions of people get hurt. Banks are the primary cause of the “business cycle.”

And so we bail out our banks. We regulate our banks. We subsidize our banks. We forcibly merge our banks. And regulate them some more.

The United States is well on the path to turning the banks into public utilities. Expect truly massive quantities of crony capitalism if the trend continues – as if the system of bank life support we’ve had since the Great Recession started wasn’t bad enough.

Want to know why the economy continues to limp along? It’s bank overregulation. The banks have reeled in their lines of credit. Businesses too small to go to Wall St. for capital are starved for cash. Meanwhile, banks offer microscopic interest rates for even long term depositors. The situation screams out for arbitrage. Enormous spreads beg to be filled.

The government is in the way.

And so Main St. suffers, and big money Wall St. capital moves into businesses once dominated by Mom and Pop players.

A Main St. Vision of Banking

Once upon a not so long time ago, there were thousands of banks that each served a single community. While I was in junior high my home town bank had no branches. It was just one nice building. The service was great. You could take a bag of coins there and make a deposit. They would count them money using their automatic counter – no hand-rolling or using Coinstar. In Texas, branch banking was illegal.

I wouldn’t go as far as making big banks with many branches illegal, but I do believe community banks which invest in their own communities vs. some far off securities market, are essential to a Main St. economy.

Not only that, I think banks can and should be realistic places to invest. Mary Lou and Bubba should be able to put their retirement money in their hometown bank and get a decent rate of interest. No need to go to the big city broker. And I don’t want everyone who isn’t a finance wizard investing in index funds; this is a way to guarantee big corporate oligarchy.

But to make community banking largely decoupled from the general financial system viable, we need to make some changes, changes that will making banking a bit more complicated in some ways, but still simpler than the sliced, diced and repackaged securities that got us into this recession.

Local Banking Made Robust

The smaller the bank, the easier it is to have a bank run. This is why our ancestors created the Federal Reserve System – to turn small bank runs into general depressions and/or long term inflation. So the first step to viable local banking is to make banks more run proof. This requires getting banks out of the business of maturity transformation. Long term loans need to be financed with long term deposits. Short term deposits should go to short term loans, such as inventory financing. We probably don’t need to go down to zero maturity transformation as the Austrian School fanatics advocate, but we do need to bring back the yield curve, and get the banks out of the business of legalized check kiting.

Community banks need to be robust against the bumps of the general economy. It is too much to expect the Federal Reserve to make inflation perfectly zero and have stable interest rates. Even if we were to eliminate the Federal Reserve and go to a gold standard, there are still the manipulations of foreign central banks and George Soros.

This means banks need to be allowed to make some windfalls to offset these risks. If a bank issues some high interest certificates of deposit in order to finance a home mortgage, and then the homeowner wants to refinance after interest rates fall, the bank has a problem. Either banks need to be able to assess penalties for early payment of long term loans, or the long term CDs need to be callable. There is no free lunch. True community banks cannot hedge all financial risks without playing the derivatives market otherwise. (In future articles we will look into how community banks can function as mini financial markets instead of using penalties to deal with this inflation/interest risk problem. This is a bit more complicated than banking today, but with the Internet and touch-screens at the banks, quite manageable today.)

There is one risk, however, that community banks should shoulder: their own loan portfolios. When banks own the mortgages that they issue, they pay careful attention to credit worthiness. Conversely, a hometown bank which is too quick to foreclose on its debtors can damage its reputation badly.

In other words, FannieMae and Freddie Mac need to go. There are better ways to encourage an ownership society.