Banks - A Better US Banking System: Two-Tier Banking

What’s your take on the state of the U.S. economy and our banking system, as we enter the seventh year of the global financial crisis?

Following the collapse of Lehman Bros., the world’s major central banks, led by the U.S. Federal Reserve, and other key institutions, took the necessary steps to avert a global financial system collapse and a reversion to the barter system. They reliquefied credit markets – albeit with an overall substantial decline in total credit offered.

As a result, no other major, financial institution outside of Lehman Bros. went under. AIG (NYSE: AIG) was saved, Citigroup (NYSE: C) and the Bank of America (NYSE: BAC), among other institutions, were helped.

However, the above is not to say that the central banks' intervention was fair. Even so, to those who say that the rescue plan did not achieve justice, the most incisive observation appears to be one by New York Time Business Columnist Floyd Norris, who at the crisis' outset astutely noted:

“The financial crisis is just one of those events in which justice and success don’t occur together.”

Global financial leaders had a choice: justice or success. They chose success. In other words, saving the system required helping some of the institutions who got us into the mess called the financial crisis in the first place.

Fair? No. Prudent? Yes.

Was that fair? No. Prudent? The view from here argues: yes. And, in truth, the central bank heads and other decision makers really had no other choice, as a practical matter. The alternative, no matter what the critics of the bank bailouts assert – would have been a financial catastrophe. The financial crisis-triggered Great Recession has been bad enough: a failure to intervene by the major central banks would have led to a calamity equal to or worse than the Great Depression of the 1930s.

Hence, when your neighbor asks you ‘what good did all the government intervention do?’ tell him or her that companies are still operating, ATMs are still functioning, the stock market is open, and banks are still at least making loans and mortgages to strong-credit businesses and home owners. In a nutshell, a balanced analysis reveals that the Fed’s and U.S. Treasury’s actions, along with interventions of central banks in other, major economic regions, averted a catastrophe.

To be sure, as most experienced investors know, averting a catastrophe does not mean the financial system has been fixed. As parents tell their children, you may be over your cold, but have you listened to what we (and the doctor) have said, so that you will avoid catching a virus in the future?

Concerning the financial industry in the United States, the financial players apparently have not. Further, given the size of the financial crisis, it’s astonishing how little has changed on Wall Street or in the regulatory framework.

‘Heads, The Banks Win; Tails, The U.S. Taxpayer Loses’

Incredibly, the system of ‘heads the banks win, tails the U.S. taxpayer loses (and pays)’ has remained intact, basically. That means, unless there are further reforms, if another big institution fails and/or creates systemic risk, the U.S. government (and governments around the world, if the failure occurs in a foreign country) will have to intervene and stabilize the institution at taxpayers’ expense, if not outright take control of the firm.

Further, and equally distressing, very little has been done to alter bank executive compensation structure. The same ‘perverse incentives’ of making fees on problematic loans is still largely in-place. The European Union wants to place limits on banker executive compensation/bonuses, but there’s little support for caps the United States, so the measure is not likely to make a meaningful difference, even if the E.U. approves caps.

Third, there appears to be little change in Wall Street’s culture of “IBG” – as in I’m going to maximize my personal gain, no matter what the cost is to the bank, or the financial system, because ‘I’ll Be Gone’ by the time it becomes clear that mistakes were made.

The above reforms will require years - and considerable policy study - to implement, but there is one reform that can go a long way toward placing moral hazard back where it belongs: in bank stockholders’ and bank executives’ laps.

Best For the United States: Two-Tier Banking

The U.S. can implement two-tier banking. In a nutshell, the U.S. Congress can charter a network of community banks - roughly 4,000 - to serve basic needs.

These community banks would be non-profit co-operatives that offer limited products: checking accounts, saving accounts, and a few, rudimentary loan products. Bank deposits would be FDIC-insured. They would not pay high salaries to executives, nor to other staff. There would be no monthly checking or savings account fees or ATM fees for debit cards, nor minimum deposits required, and the interest offered on each account would be nominal - well below market rates.

In other words, these community banks would emphasize services that meet the needs of the typical American - the typical person - and would not be permitted to make large loans, or deploy exotic financial products. They would also take advantage of efficiencies triggered by the Internet to substantially and radically lower overhead costs. How clow can costs go? Try a charge of 25 cents to transfer $1,000 to another bank - not $3 or $10 as some banks currently charge. And, as noted, the staff of these community banks – public servants extraordinaire – would be paid modest salaries.

In short, the community banks’ mission would be meeting needs of most citizens – something altogether appropriate for the U.S. government to backstop with FDIC insurance.

Investment Banks

The second tier of would be the investment banks. These banks would be free to pay high executive salaries, offer exotic loan and investment products – including commercial mortgages, bonds, trading services, and derivatives etc. And these banks can pay high interest rates.

The key difference: the investment banks would receive no U.S. government insurance and deposits would not be FDIC insured. Not one dime. Every loan loss, every derivative counter-party failure, every absurd executive compensation or bonus schedule, every trading program gone awry will be on the backs of the banks’ stockholders.

A Better Banking System

In sum, many steps are needed to prevent another financial crisis. And the changes are likely to take a decade, probably longer. But a two-tier banking system would be a huge step in the correct and constructive direction.

Congress should establish a network of FDIC-insured community banks – roughly 4,000 - to serve basic needs.

Meanwhile, investment banks should be premitted to go about their merry way. They can win big, or lose big - but under this new system proposed above, they won’t be allowed to lose big on the taxpayers’ dime.

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Follow Joseph Lazzaro on Twitter: @JosephLazzaro.