Fixing Banks through Tighter Lending Restrictions

Since the beginning of the Republic, there have been at least 16 banking panics, all due to banks loaning out far more than they had deposited. To prevent future bubbles, then, the fix is obvious.

Fixing the banks is of direct importance to each of us. But it is such an arcane subject that most Americans, docs included, get a brain freeze when they see the subject and take a pass.

An op-ed piece in the Wall Street Journal recently opened the clouds for me and I thought I'd share the author's insights for those who don't read the WSJ. It might help getting a relatively simple handle on the mess we're wading through. And, as in most things complex, Occam's Razor, the likelihood that a simple explanation is usually the best, may well apply here.

The author, Andy Kessler, a former hedge fund manager, has identified at least 16 banking panics since the beginning of the Republic. And he says that they all have one thing in common; the banks loaned out much more than they had deposited. A bank loan virtually creates new money, which up to a point, is a good thing. It greases the wheels of commerce and allows the economy to grow. Fair enough.

But if something goes amiss, like a value bubble bursting, as the tech bubble did in 2000 or the real estate melt down in 2008, when the system backs up and people want their money back, there isn't enough left to return their deposits, let alone make any gain.

This used to be called a "run on the bank" because people would run to get their money before the music stopped. You know, like musical chairs where the last one standing loses out. The FDIC does provides a cushion for individuals, up to $250,000, but not for the integrity of the system itself, unfortunately.

The government has a say in this arrangement because it can require a minimum cash to loan ratio for lenders that it deems prudent. The dicey part is that if the ratio is too strict, say 1 to 1, growth is stifled. If it is too loose, down as low as 20 to 1, you can get what just happened to us.

Everyone agrees this is a once in a generation opportunity to hit the reset button to a more prudent level of regulation. Why? Because the traditional demand from the banks to keep their profits high by maximizing the amount that they can loan, can temporarily be muffled by the populist uproar against the banking industry.

Mr. Kessler suggests raising the capital-to-reserve ratio by 1% a year from the current 10% until 2020 when the number would hit 20%. This would restrain the amount of money that banks could create by issuing new loans, thereby softening a rush to a new bubble, and cushioning any call on the banks when a given market like real estate may slump. And a slow, planned change would minimize any disruptive shock to the economic markets. A 5:1 loan ratio is a fair compromise between growth, increased prudence and public confidence and the bank's ability to profit.

And while I am at it, let's talk about a simple fix to specifically prevent any related mortgage collapse in the future. Recent research has shown that it really wasn't the sub-prime market alone to blame for the collapse. No, foreclosures actually soared amongst middle class/credit families even more if they didn't have any meaningful down payment. It turns out that the chief fault in foreclosures was not having "any skin in the game."

Yes there was fraud and yes there was a lack of oversight of the secondary mortgage market where lenders palmed off to investors what they said were "secure" mortgages. But it was largely people who had no equity stake in their home who formed the corpus of foreclosures. A perfect storm of irresponsibility on the part of regulators, lenders, and buyers.

So, to fix the system, to prevent future mortgage-related banking debacles without hamstringing our economic growth, let's start with three changes:

  1. Raise the capital requirement for lenders as Mr. Kessler suggested (you can argue about the timing and the amount amongst yourselves).
  2. Require home loans to be based on a meaningful down payment to keep lenders and buyers behaving prudentally (traditionally it has been 20% - I don't know why).
  3. Even if mortgages are allowed to be "monetized" by bundling and reselling to investors, make sure the original lender has to keep a stake in that loan and has to oversee it. In the end, the conceptual key to revising the banking rules to prevent the 17th bank "panic" is the same fix as for so many other public problems; transparency and accountability.

Is that so hard?