Thursday, May 31, 2012

Banking Regulation Done Right!

There is an article of faith among conservatives that banking can't be regulated.   They theorize that no matter what laws you pass, there will always be some smart, unethical genius that will find a loophole.

But this is wrong.  Fundamentally wrong.  Their logic depends upon assuming regulation is "negative regulation".  That is, the regulations tell you what you can't do.  "No buying junk mortgages",  "No betting on horses", etc.   Then of course,  lobbyists and congress put in lots of exceptions.   Then these exceptions get abused or someone finds something new (or convinces people it is new) and abuse begins again.

But we don't have to do 'negative regulations'.  Instead put in place a system of positive regulation.  That is tell banks what they are allowed to do rather than what they can't do.  Anything not on the approved list can't be done by the bank - but bank owned subsidiaries can do (as long as their are legal protections that prevent the bank from being fiscally responsible for the subsidiaries' debts.)  If someone truly invents something new it is by law automatically prohibited. 

This will practically (not perfectly), end all banking crisis. Here is what the bank would be allowed to do - and no more:

  1. Accept money and securities  that others own  -paying interest or other reasonable considerations in exchange for the right to loan it out (see #3 below).
  2. The bank itself may own, purchase or accept as collateral property: debt, stock or other securities approved by the SEC for sale that do not under any circumstance require the owner to provide additional monetary support (not even stock options). 
  3. It can loan out anything it owns or a customer owns (and has given permission to loan out in rule 1) to other customers.
  4. Act as Agent (not broker-dealer) and accept fees for assisting customers.  The bank has a legal fiduciary obligation to give the best possible advice to said customers.   They act as agent, NEVER as dealer (i.e. own something and sell it to their clients).
  5. In order to sell anything they own, they must hire an Agent.   This agent can not use the bank's property (intellectual or physical) for advertising purposes.  No mailings to the bank's customers, no brochures on the bank property, etc.  No 'advantage' at all to the bank's customers.  The bank is not in the business of selling things to their clients, as this presents a conflict of interest, so it must hire other people to do so.
  6. Own subsidiaries that have limited liability (protecting the bank), that are not subject to any of the above rules.

They would be legally forbidden from engaging in any truly risky behavior.  If they want to do other things, they can, but only through  a subsidiary that specifically limited liability.  That is, if the subsidiary goes bankrupt, the bank would not have to cover it's losses.

If the bank tries to violate these laws, any contracts they made that violated them is declared null and void.   The people that signed those contracts would be subject to prison terms of no less than 2 years in jail, prevented from ever working for a bank again, and the contract is null and void. The court should do it's best to undo the trade but under no circumstances does the bank owe more money.

This system has multiple advantages.  First, it protects the banks from stupid risks.  They can't take on unlimited risks, only their subsidiaries can.   This prevents those risks from bankrupting the banks.

Second, it lets the banks invest their money in risky things - but only through owned subsidiaries.  They can pump any money that is not needed for their banking operations into the subsidiaries and do the funky investments there, as opposed to risking their customer's money.

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