A Better Plan for the Banking System

It is clear by now we have to address the problem of our banking system, which is at the heart of our predicament. Without sound banks, credit doesn't flow and the entire economy is at a standstill.

It is also clear we can't keep digging the hole we are in, throwing good money after bad by trying to bail out every insolvent bank and backstop every bad mortgage. Moreover, usurping private industry is an expensive proposition with dreadful unintended consequences. Once a few banks are nationalized, shareholders will ditch all others, fearing that their stock would soon be worthless as well. These banks would then also need government support.

The guarantees that the US government has already extended to the banks, and the large but in hindsight inadequate capital proffered them under the Troubled Assets Relief Program (TARP), is not dissimilar from those given by the Japanese government in the mid-1990's to resuscitate their major banks. The result there was that the Japanese banks used the cash to effectively transfer the losses to the taxpayers. Subsequently, they were still undercapitalized, and prolonged the credit crunch and the bubble's terrible consequences. Between 1992 and 1998 the cost to the Japanese economy from bad lending quadrupled from 5% of GDP to over 20% of GDP.

That is happening here now. We are keeping appearances, making believe that those toxic assets are worth more than they trade for today. This is not a strategy, but a desperate act to avoid short term pain. It will exacerbate our problems and create an unbearable financial burden that might crush us.

We have to face the banking crisis head on, and the sooner we do it the better. Banks need to be disciplined; those that can't survive must go. When that happens, the better managed, better capitalized banks can distinguish themselves. Otherwise we are wearing down the incentive of the more viable banks to engage in good lending as opposed to self-preservation and sucking up more of Washington's cash.

Instead of spending more money on the failed institutions, which is Sisyphean and wasteful, why not follow the suggestion of my friend Mike Meixler, an Arizona money manager, and dedicate $100 billion from the TARP budget to creating community banks? Take the money earmarked to large, corrupt and failing banks that wretchedly brought us to the precipice, and have the FDIC offer matching capital to anyone setting up a new community bank.

Say someone in Stockton, Calif. puts up $25mm to launch a community bank. Washington provides an additional $25mm, and asks for nothing in return except that the new bank will be supervised by the FDIC and comply with regulatory requirements. We limit the new community banks to no more than $100mm each and no more than two banks per population of 500,000, to make sure they are spread around.

This will attract many savvy business people because they can double their equity on day one. It will rejuvenate the banking industry because you will now have new community banks unsaddled by toxic assets, with pristine balance sheet and eager to lend; and magnified by the reserve ratio, it will create available credit at least 20 times the capital the government provides.

That is a much better solution to the banking industry than anything I have seen from Washington thus far. I am aware that the government will not get its money back, as this is not a loan. But I doubt we will see our money back from Citigroup or the other troubled banks, so we might as well spend it wisely on people that are deserving and can actually do some good with it.

The only argument against this proposal is that it will put the large banks out of business. But they are effectively insolvent anyhow, and are not lending the new money they got from the Treasury because they are afraid it will not be sufficient to support their huge liabilities from the glory days. So let those foolish banks go. The more we delay solving this crisis, the more damage to the system, the more pain for the stock market and the higher the ultimate price to fix the banking crisis.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at [e-mail].

Comments

[ThomH]

Fine, but completely beside the point if the money and banking system used by us and the rest of the world is INHERENTLY UNSUSTAINABLE. As, alas, it is, though you would never know it, because all the "experts" tacitly assume that it IS sustainable and needs only "correction" to get it back on a stable track: bailouts, stimulus, "proper regulation".

But as soon as you understand that almost all our money is debt created by banks, who are owed both that debt plus its accrued interest, which adds up to more than all the money outstanding, so additional debt must be created to account for the interest, you realize that the system requires that debt must keep increasing without limit forever. But it can't. Nothing can.

When total debt reaches its upper limit, borrowers begin defaulting and banks begin failing, producing a credit freeze and economic slowdown, as now.

AND THIS HAPPENS EVEN IF REGULATION IS PRISTINE, AND BORROWERS AND LENDERS ARE ALL HONEST.

It's time to stop searching for scapegoats and begin replacing a badly broken system with one that will work sustainably.

End fractional reserve banking. Stop the creation of "credit money" by private banks. Require full reserves for all lending. Pull money creation back to the Treasury where it belongs.

Federalize the Fed. Grow with Greenbacks.

Nothing else will work.

[Guitarsandmore]

After the civil war Abe Lincoln created the U.S. note to pay off the war debt. The U.S. note is printed by congress, carries no debt, and pays no interest. U.S. notes or Greenbacks as they were known remained in circulation until just recently.

The right way to recapitalize the banks is for the treasury to buy up all the U.S. bonds with U.S. notes. When the notes are deposited in the banks the banks become whole again.

Why should Obama borrow money from the FED driving the taxpayers further into debt when he can have the treasury print U.S. notes?

Fractionalized reserve lending should be outlawed. Presently when banks loan money they are allowed to loan ten times what they actually have. That means if a bank loans out a thousand dollars at eight percent interest they are actually making eighty percent interest because they loan out the same thousand dollars ten times. This is called fractionalized reserve lending.

This scam only works when the economy is expanding and there are plenty of profits to cover it all up. When the economy is contracting then people are defaulting on money that wasn’t even there to begin with. Its ugly.

[Henry]

"The only argument against this proposal is that it will put the large banks out of business. But they are effectively insolvent anyhow,"

Al,
Either Ben Bernanke is lying, or you are misstating the facts of the matter. Ben stated on tv in front of the nation that the big banks are adequately capitalized, yet you state they are effectively insolvent. Who is a person to believe, the head of the Fed, or you? If you really believe what you state, you are obligated to prove that Ben is lying to the country. One of the two of you is not stating the truth.