Practical analysis for investment professionals
12 July 2011

Limited-Purpose Banking: Can It Fix the Financial System?

Posted In: Future States

Jimmy Stewart Is Dead.

It’s not an obituary. It’s the title of a recent book by Laurence Kotlikoff, a prominent economist and a professor at Boston University. The title is referring to the 1940s feel-good movie, It’s a Wonderful Life in which James Stewart plays the role of an honest and selfless banker running a simple savings and loans institution.

Despite his integrity and the simplicity of his financial operations, Jimmy faces a run on his institution. In part because it is following the inherently problematic though age-old banking methodology of borrowing short and lending long. As Jimmy is about to commit suicide, his guardian angel rescues him and everything takes a turn for the better.

No such luck in real life! It is taxpayers and not angels rescuing financiers, and the economic outlook remains uncertain.

Kotlikoff is telling us that we do not live in an age of selfless financiers. In addition, finance is much more complex compared to the 1940s. Nonetheless, borrowing short and lending long is still how banking is done. Referring to the financial crisis that started in 2007, Kotlikoff says “it’s a horrible mess.” It has caused tremendous suffering for millions, especially for those that it has put out of work.

To avoid a repeat of the same, Kotlikoff suggests a fundamental reform: “limited-purpose banking.” He explains that it has three main features:

First, as implied by its name, limited-purpose banking limits the role of banks to financial intermediation. Banks will not extend credit themselves but operate as companies offering mutual funds that do not borrow to invest. These mutual funds — there are already about 10,000 in the U.S. — will buy the assets specified in their charters, be they mortgages or corporate bonds. The payment system would function through cash-only mutual funds. Banks will not be able to expand the money supply and the government would have full control of the money supply (M1) — something a number of economists, including Milton Friedman, have long advocated.

Unlimited liability will apply to those financial institutions, such as hedge funds, that cannot work as mutual funds. That is, the personal wealth of those who want to speculate on borrowed money will no longer be safe from their actions.

The second feature of limited-purpose banking is heightened transparency. A single financial regulator will take the lead in ensuring safe custody of mutual fund securities and transparency in underlying transactions. This should help prevent fraud as exemplified by Bernie Madoff, as well as the so-called liar loans that plagued mortgage underwriting, and toxic assets such as collateralized debt obligations (CDOs).

The third feature of limited-purpose banking is that financing by mutual funds would be done via online auctions. For example, once the regulator has ensured transparency in the mortgage that you want, it will be bought by a mutual fund in a similar way in which you buy things from online auctioneer eBay.

This, in short, is how limited-purpose banking “moves us from trust-me banking to show-me banking” to avoid a repeat of the ongoing financial crisis.

Does that sound radical? “It’s not radical,” argues Kotlikoff. “What is radical is maintaining the current financial system.”

Limited-purpose banking is not without its supporters. Those who have praised Jimmy Stewart Is Dead include five Nobel laureates in economics and some known policymakers like George Shultz, former U.S. secretary of the Treasury. Mervyn King, the governor of the Bank of England, has also talked about Kotlikoff’s “much wider vision of how the financial system can ultimately end.”

To learn more about limited-purpose banking, listen to this 13-minute educational audio podcast (MP3) by CFA Institute, “Limited-Purpose Banking: Can It Fix the Financial System?” featuring Boston University Professor Laurence Kotlikoff.

About the Author(s)
Usman Hayat, CFA

Usman Hayat, CFA, writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals;" the literature review, "Islamic Finance: Ethics, Concepts, Practice;" and the research report "Sustainable, Responsible, and Impact Investing and Islamic Finance: Similarities and Differences." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in development economics. He has served as a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP) and former CEO of the Audit Oversight Board (Pakistan). His personal interests include reading and hiking.

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