09/29/2011 05:22 pm ET | Updated Nov 29, 2011

Imagining a World Without Banks

PIMCO's Bill Gross has remarked that our nation became a superpower because "we were getting richer by making things, not paper." Unfortunately, for the last few decades, our nation has primarily grown weaker by making worthless paper in a variety of ways -- junk bonds, subprime mortgages, and countless types of derivatives -- through banks. If we step back and ask ourselves what banks were originally designed to do, it was simply a depository where people with savings can store their wealth, and borrowers could access capital to pursue investment opportunities.

Today those simple functions can be easily replaced by software. After all, from a savings perspective, are there material differences between a checking account at Citicorp versus one at Bank of America? Do we really need thousands of banks and bank branches spread around the country when we have the internet to make distance of banks irrelevant? If these banks are essentially backed by the government because they are too big to fail, why not just buy U.S. Treasury bonds to park your savings? It would be easy enough to use Google as the banking interface and park your money with the U.S. Treasury or the Federal Reserve in lieu of a bank.

From a lending perspective, the banks clearly have failed to allocate their resources to investment opportunities that would power economic growth into the 21st century. Their cash has primarily been used for short-term profit opportunities such as speculating in the capital markets for quick profits, leaving many small and medium sized businesses cash-strapped. Instead, if we engage in this thought experiment, wouldn't it make more sense to leave the lending, and/or investing to the savers themselves? In this hypothetical world, individuals can save by stashing their cash directly with the Treasury or Federal Reserve. But if they want to invest in promising companies and potentially earn a return higher than they can through T-bills, they could do so by investing their cash in other financial institutions or companies not backed by the U.S. government such as mutual funds. By eliminating banks with captive capital, investors do not have to worry about moral hazard and uneven playing fields that develop when banks have too much power. If companies need loans, they can apply through some central marketplace like eBay and attract the funds from savers and investors who have larger risk appetites. In short, all the basic functions that a bank does today can be easily replaced by software that enables individuals and companies to achieve their savings and investment outcomes much more inexpensively, efficiently, and productively.

Defenders of banks would argue that banks also economize -- when properly functioning because of proper regulation -so-called 'monitoring' costs. The argument goes something like this: if you, I, and a bunch of other people all separately lent money to some big borrower, we might all in effect replicate each other's efforts in investigating the credit-worthiness of the borrower. Alternatively, since each of us would be only a small lender, we might simply refrain from monitoring altogether, and accordingly subject ourselves to considerable aggregate risk that could have been minimized had somebody monitored on behalf of us all. That would be 'socially inefficient.'

This argument would make sense if compensation to loan officers were tied to the performance of the loans they made. However, the reality is that most loan officers merely make loans based on guidelines that could be easily automated. Monitoring loans is more likely to be better served by constant communication between many well-informed individuals similar to what happens on Wikipedia because the costs are not socialized by the government. Furthermore, the savers/investors can insist on a full list of lenders from any borrower to be disclosed by signing a non-disclosure agreement. Finally, if there is enough interest in loan monitoring services, more independent research firms could spring up that charge a fee for providing ongoing monitoring reports and would lessen the likelihood of a conflict of interest for hiding bad loans which exists today. The costs of this approach would not cost trillions of dollars which is what the current price tag is for keeping the banks afloat.

While a return to Glass-Steagall has often been offered as a solution, it doesn't go far enough. First, given the commoditization of banking services, a separation of commercial banks would likely lead to large scale bankruptcies of banks anyway. Why have all these large physical banks when Africans and Indians have shown that microloans work even better? If the banks are to survive, they will again make riskier loans to profit as they did during the S&L debacle and cause yet another crisis for taxpayers to mop up. How many times do we have to make the same mistake before we learn our lesson? The way to real growth is through lending to investments in the future and consumption based on savings, not out of control credit growth by banks.

The endless portfolio of "financial innovations" such as equity derivatives, credit derivatives, and other complex financial contracts should be left for those risk-loving entrepreneurs who want to risk their own money instead of other people's money playing in that market. This way, they are free to innovate as much as they want. But without the guarantee of Uncle Sam to bail out their bad bets, these speculators would likely keep their speculative bets within reason or exit those markets altogether as any gambler who has run out of money playing in a casino would do. This would also save government the need to hire armies of regulators who are next to useless in the current environment from stopping the next financial crisis. Smaller firms playing with their own cash are unlikely to entangle the entire world with their risky behavior.

Of course, the biggest immediate hurdle we would face to achieving a more responsive and productive banking system is the large unemployment this will cause in the banking sector given that unemployment rates are already elevated. However, these people could be retrained for more productive professions or they may seek to become entrepreneurs. Like a cancer that has caused the rest of the economy to get sick, the banking tumor that has grown out of control must be removed or it will eventually kill the whole economy. Better to have a sick patient in intensive care for a few years who will have a chance to recover than a dead one.