Won’t Banking Be Splendid When Risk Is Whisked Away : Finance: Reform proposals envision banks that are bold lenders but cozily secure holders of deposits. Impossible.

Listening to the typical House member or senator discuss banking reform is akin to listening to proposals for Congress to promise every American a trip to the moon by the year 2000. While both discussions have a distinct air of impossibility about them, the trip to the moon would probably be cheaper.

There are two things that Congress wants from banks. First, they must offer depositors a “riskless” asset. Second, and simultaneously, they want banks to be ready and able to provide loans to any household or business that seeks them in their districts.

The preferred method of offering riskless assets is through deposit insurance. The quid pro quo for deposit insurance is some restriction on bank activities, primarily an exclusion from the investment-banking business under the Glass-Steagall Act of 1933. However, the erosion of the value of the banking franchise through the growth of intermediary services by money markets, insurance companies and others has placed the banks under considerable pressure to expand their lending into decidedly risky areas, such as real estate and other regional activities. The only way banks have been able to continue to attract deposits is by attempting to match the interest rates of other financial institutions while also offering insured deposits.

As banks have moved into risky real estate lending while offering “riskless” assets to depositors, a new kind of recession has emerged. Rather than the typical one that results from too much production by the manufacturing sector, excessive inventories and an inventory sell-off, this recession was caused by too much lending by commercial banks, leading to an excess stock of commercial real estate. As the number of unoccupied office buildings grew to equal about a six-year supply, the banks, as effective owners of the office space, ended up holding the bag. Empty offices generate no cash flow and therefore an inability to service the debt from the purchase of the building. Real-estate lending turns out to be as risky as lending to Third World countries, and banks as suppliers of riskless assets place heavy demands on federal deposit insurance.

The only way out of the difficulty that financial institutions find themselves in is to recognize that those offering riskless assets must be severely restrained. Specifically, we need to create a narrow class of banks that invest only in Treasury bills and compete only in terms of offering depositors services at the lowest cost. In return, this narrow class of banks would be insured by the federal government.

All other banks would offer uninsured deposits but in return they would be permitted to enter into any of the activities now undertaken by other financial institutions, including investment banking, nationwide banking, insurance services and similar activities. These institutions would be able to offer depositors a higher rate of return, but depositors would have to understand that investing in such institutions is akin to buying stock and should only be undertaken while carefully examining the investment practices of the institution. The effect of this dichotomy between riskless banks and banks that perform like any other financial institution would be to end the internal inconsistency plaguing today’s banks: They are asked to be all things to all people in exchange for deposit insurance. As a result, they try to offer riskless assets while engaging in risky investments. The final result is a large bill for the deposit-insurance fund that must be paid by the taxpayer, as in the case of savings and loans, which also suffer from ambivalence.

Right now, the Treasury and Congress are flirting with banking reform. So far, the proposals have failed to recognize the need to separate riskless banks from normal financial institutions. The desire to let banks and depositors have their cake and eat it, too, by making believe that depositors can acquire riskless assets in institutions that engage in risky activities will, if adopted, be very expensive.

In effect, this amounts to another entitlement program, whereby the government assures Americans that in exchange for higher taxes they needn’t exercise any normal prudence in the selection of institutions in which they invest. Such bogus financial security will be expensive, and if we proceed down that road we had better set up a deposit insurance trust fund to pay for the inevitable bailouts.

The best way to benefit from wishful thinking about regulation of financial institutions will be to take up residence abroad, terminate one’s American citizenship and enjoy the high rates of return offered by American financial institutions that ensure that deposits will not face constraints on their investment activities. That way it will be possible to enjoy the benefits of the American financial have-your-cake-and-eat-it-too scheme without paying the piper as an American taxpayer.