The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.NEW YORK ( TheStreet) -- U.S. bank purchases, packaging and trading of mortgages and their derivatives in late 2008 resulted in the U.S. banking collapse and the global recession. European bank purchases and packaging of Greek and other sovereign debt is close to causing another global meltdown. That leads to the question posed by the title: What should we do about it? In the following article, I consider several viewpoints on what should be done.
The Bhidé and Lounsbury SuggestionsIn
- governments should fully guarantee all bank deposits;
governments should impose much tighter restrictions on risk-taking by banks;
banks should be forced to shed activities, like derivatives trading, that regulators cannot easily examine.
- "...the depository function of banks should be regulated as are public utilities. That public utility function is in fact institutionalized by the FDIC within the depository limits of that program. The investments associated with such deposits should be regulated to a much higher security/risk standard than many other forms of banking traditionally known as investment banking. It is only logical that the public utility should be segregated from the investment banking activities."
Guaranteeing Bank Deposits
- "A bank run occurs when depositors, worried about the safety of their deposits, pull them out. This causes real problems inasmuch as most banks keep less than 10% of their deposits in cash. So what would I do if I had euros deposited in any eurozone bank? That is easy. I would pull them out immediately and stuff them under a mattress.
Tighter Restrictions on Risk-TakingBoth Bhidé and Lounsbury believe risks should be lowered and more tightly regulated in depository banks.
- "There are a couple of problems
How Do We Get There?Two steps need to be taken: 1. Split off bank trading operations;
2. Require banks to make, hold, and manage their own loans.
Split Off Bank Trading OperationsParameswaran is horrified by this notion and does not think it can be done:
- "Amar Bhide's idea essentially seeks to turn back the clock and forbid much of the innovation that has taken place in the last few decades."
- "There is simply no way that large banks, especially those with a large OTC derivatives franchise, can shed their derivatives business and still remain solvent."
Require Banks to Make, Hold and Manage Their Own LoansThis is what banks did (before the "innovations"), and it required them to focus on the spread -- the difference between what they paid to attract deposits and what they made on their loans. This was their life blood -- their loans could not fail or they would collapse. Think how different the incentives are today -- buy, package and sell loans -- make money on the commissions -- don't worry about the quality of loans, you will be selling them off -- the more you sell off, the more commissions you make. Why did the market for mortgage-backed securities hold up so well when everyone knew there was a real estate cycle? Why was anyone buying Greek sovereign debt in 2007, when it was clear Greece was on a non-sustainable path? Because the banks did not care about risk: They planned to sell everything off and make money on the commissions. Will this change really make a difference? I think so: The incentive change is so profound that banks will again be forced to think seriously about the quality of the loans they are making. Parameswaran disagrees:
- "Although this would seem to be a sufficiently narrow mandate to prevent rent extraction, it is not. Banks can simply lend to other firms that take on negatively skewed bets. You may counter that banks should only be allowed to lend to real economy firms. But do we expect regulators to audit not only the banks under their watch but also the firms to whom they lend money?... I outlined how the synthetic super-senior CDO tranche was the quintessential rent-extraction product of the derivatives revolution. But at its core, the super-senior tranche is simply a severely negatively skewed bond -- a product that pays a small positive spread in good times and loses you all your money in bad times. There is no shortage of ways in which such a negatively skewed payoff can be constructed by simple structured bank loans."