The Bankwatch

Tracking the consumer evolution of financial services

Limited Purpose Banking using Mutual Funds to replace banks

I recently covered Mervyn Kings proposal for Utility Banking; a banking business model that separates banking banking services from high risk investments. For example utility banking as I see it, would cover day to day chequing, savings, loans and mortgages, ATM’s, and online banking. It would have traditional FDIC type deposit insurance, and utility banks would be subject to capital requirements and would not be permitted to participate in off balance sheet banking, nor securitisation. Think James Stewart and ‘Its a Wonderful Life’.

In this piece Niall Ferguson takes it further suggesting that the Utility Banking approach still leaves the potential for Too Big Too Fail (TBTF’s) institutions that would inevitably be bailed out by governments, and therefore taxpayers.

How to take moral hazard out of banking | FT

Thus, Glass-Steagall and narrow banking treat only a part of our financial tumour, leaving the rest to metastasize. Limited purpose banking (LPB) is the only credible cure. It transforms all financial companies with limited liability, including insurance corporations, into pass-through mutual fund companies. Limited purpose banks would process securities and sell them to mutual funds. They would not be permitted to borrow to invest. Hence, they would never face a run and never fail. Risk-taking would be done by us, the people, via our purchase of more or less risky mutual funds.

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.

Under LPB people would be able to use cheques, debit cards and ATMs to draw on their cash mutual funds. Insurance mutual funds would permit people to diversify individual and share aggregate risks

This model of Limited Purpose Banking (LPB) would convert all banking to Mutual Funds. The different types of banking and investment requirements would be accommodated by alternative Mutual Fund types, from cash Mutual Funds to more speculative investment Mutual Funds. The Utility bank would be replaced by a cash Mutual Fund.

Niall makes the point that the dollar for dollar nature of Mutual Funds would solve the capital problem, and the ultimate risk would always be absorbed by the investor, ergo no bailouts required.

Relevance to Bankwatch:
It remains clear that the current banking model is not sustainable, and is prone to catastrophe. It is also clear that despite the stock market growth in 2009 that banking is not anywhere close to recovery. The banking results have reflected high investment returns, and mask the poor performance of retail banking. Consumers are retrenching and will be doing so for some time.

Further the need to solve the matters of transparency, and effective risk assessment has not been addressed in debt markets. Banks are continuing to operate as in pre 2007 times in those markets.

There is a potential for alternative banking models and it may be surprising where and when they begin to appear.

[categories profitability, business models]

Written by Colin Henderson

December 2, 2009 at 21:23

2 Responses

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  1. Agree with this model. However, the average person will never comprehend this so transparency, plain language and openness is key. Otherwise, easy for smoke and mirrors. And regulators are key.

    However, in the securities sector where the Chinese Wall supposedly exists, much takes place off hours. After all, the club is small and exclusive and much conversation takes place on the golf course, over dinners, and at after work drinks.

    So besides structural change, it is key to look at recruitment and selection. Are the banks changing their hiring model and adjusting personal qualities to reflect the public sensitivity to the cavalier attitudes of many in the industry. Structure only goes so far. Attitude takes us the rest of the way.

    deborah nixon

    December 8, 2009 at 13:55

  2. While I agree with the sentiments relative to Banks, this new model would be different … ie not banks, at least not as we know them today.

    Colin Henderson

    December 11, 2009 at 02:48

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