illustrations by steven salerno

Traditional Banking


LARRY KOTLIKOFF is a professor of economics at Boston University. His most recent book is Money Magic: An Economist’s Secrets to More Money, Less Risk, and a Better Life.

Published January 23, 2024


What do the 48 recessions since the founding of our country have in common? Financial panic, financial crisis – you pick the moniker. Indeed, one in five recessions have panic or crisis attached to their names. The Great Financial Crisis of 2008 probably comes to mind first, but historians will be happy to tell you about the Panic of 1907, the Panic of 1857 – or even the Panic of 1792, which occurred just two years after the Constitution was ratified. ¶ By my count, the U.S. has averaged a financial crisis, if not a wholesale run-for-yourmoney panic, every 15 years. Add 15 years to the unfortunate year of 2008 and you get 2023. We seem to have escaped the 15-year itch, but maybe our luck will run out in 2024. ¶ Since last March, we’ve seen the demise of Silicon Valley Bank, Signature Bank and First Republic Bank. Yes, some banks fail every year, typically disappearing with hardly a trace over a weekend when the FDIC lowers the boom. But these three were the third, fourth, and second largest bank failures, respectively, in U.S. history!

To be sure, commercial banks were a sideshow in the 2008 crisis, which featured the failures of massive financial companies, including Lehman Brothers, Bear Stearns and AIG. Lehman and Bear were investment banks, jacks of many trades that do not take deposits, while AIG was an insurance company. But there was a clear and present danger that the banks, too, would be engulfed.

Do these episodes of financial panic amount to Groundhog Day events that we are doomed to repeat? Yes, if all we do after each trauma is tighten a few nuts and bolts and pronounce the system fit for another few years. But no, if we are prepared to try something entirely different.
Read on.

Banks Failing Yet Again?
Tell Me it Ain’t So!

In the case of the failures of these three banks with combined assets exceeding half a trillion dollars, the proximate cause was the bankers’ neglect of risks linked to changing market interest rates inherent in even default-proof bonds, coupled with legal but misleading accounting practices – and, alas, regulators’ neglect. The three banks purchased longer-term U.S. Treasury and high quality private-sector securities that yielded low (but better-than nothing) returns at a time when the Federal Reserve kept interest rates close to zero. Then, Fed policy changed and rates headed north. These “safe” assets plunged in value on the open market, leaving the banks insolvent on a “mark-to-market” (valued at market prices) basis.

The three banks had kept their investors in the dark (legally) by valuing their assets on their books at their purchase cost. This is no different from pretending a rock is worth its weight in gold when it’s painted gold – well, maybe a little different, but you get the idea. The three banks maintained this charade until SVB (Silicon Valley Bank) had to sell securities in order to return depositors’ money, acknowledging that all that glittered was not gold.

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How did we get to the place where banks could take such risks and government accountants would turn a blind eye? Who knows. That’s a speculation for another essay. What we do know is that SVB’s forced admission that its assets were worth far less than their face value sparked a classic bank run – the kind pictured in It’s a Wonderful Life. But the three banks lacked a Jimmy Stewart to dissuade depositors from taking their money and running.

Those figuratively running, by the way, weren’t the good citizens of small-town- America Bedford Falls conjured by Frank Capra. They were mostly sophisticated corporations that ought to have known better, including the internet giant Roku, which had $487 million in deposits at SVB. And as most of the folks reading this article know, the limit on FDIC deposit insurance is $250,000 – a wee bit less than $487 million.

So when SVB was caught short, every depositor lacking deposit insurance started pounding the keys on their computers, transferring funds to safer climes. SVB lost $42 billion in deposits in 48 hours.

At that point, the FDIC stepped in and closed down the bank. Treasury Secretary Yellen then declared SVB to be “systemically” important to the stability of banking. Translation: all depositors, uninsured and insured, would be made whole. She also announced that insuring uninsured depositors after the fact was only something on which depositors in systemically important banks could depend. This means that small- and mediumsized uninsured depositors – think, for example, of a local supermarket that keeps $1 million on hand to cover vendors’ bills – have no guarantee their money won’t be vulnerable the second after big depositors’ catch a whiff of the odor of insolvency.

Our Clear and Present Financial Danger

One reason this last banking crunch feels like déjà vu all over again was the international fallout. What happens on Wall Street rarely stays on Wall Street. Nine days after SVB died (and seven days after Signature Bank followed), Credit Suisse met its maker. And Credit Suisse plays in a very different league. At the time, it was Switzerland’s second largest bank, whose importance as a global wealth manager far exceeded its size as a deposittaker before it went belly-up. The corpse was purchased for centimes on the franc by UBS (assets under management: $4 trillion) – this despite (or perhaps because of) Credit Suisse’s receipt of a $58 billion loan from the Swiss central bank four days earlier.

The run on Credit Suisse leading up to its demise should have been no surprise in the wake of SVB, Signature and First Republic. As with the American three, the run was fueled by uninsured depositors and other nervous creditors.

Uninsured depositors take down three huge U.S. banks. Uninsured foreigner depositors take down Credit Suisse. Gee? What more could happen over here and over there? A lot more. Let’s start with these two interesting factoids. First, on a mark-to-market basis, over half of FDIC-insured banks are currently insolvent – their liabilities (mostly deposits) exceed their assets over $2 trillion (no misprint). Second, two of every five dollars deposited in U.S. banks are uninsured.

The run on Credit Suisse should have been no surprise in the wake of SVB, Signature and First Republic. As with the American three, the run was fueled by uninsured depositors and other nervous creditors.

It’s not surprising, then, that in the days and weeks after SVB failed, $600 billion of the close to $8 trillion of uninsured deposits in U.S. banks headed for the hills. Much of the money fled to 100 percent equity-financed money market mutual funds – funds that can’t borrow money and thus can’t be subject to interest-rate-driven implosions. And a whole lot of the rest ended up in systemically important (i.e., too important to fail) banks, like JPMorgan Chase and Bank of America, which now hold almost one-third of all U.S. bank deposits. But that’s hardly the end of the potential for bank failure since 40 percent of bank deposits remain uninsured.

Who’s Moving Next?

What’s to keep the remaining uninsured depositors in small- and medium-sized U.S. banks from pulling the plug? The answer is a clearly unsustainable bribe that these smalland medium-fry are paying in the form of high rates to retain deposits.

Why unsustainable? Because roughly half of them are insolvent on a marked-to-market basis, meaning they will either need to quickly start making extraordinary profits on their costly borrowings/deposits or be forced to recognize losses year after year until the FDIC closes their doors or their depositors decide to bolt. Those among my readers with gray hair may recall an eerily similar slow motion crash – the savings and loan crisis that began in 1986, lasted nine years, and took down over 1000 banks (32 percent of the total).

What applies to the U.S. applies elsewhere. What’s to keep uninsured depositors in the global European banks from moving their investments into safer harbors? After all, had UBS not been forced/bribed by the Swiss government to buy Credit Suisse, foreign depositors would have lost a good chunk of their $1 trillion.

And what’s to keep uninsured depositors in our mega-banks from moving their money to safety – i.e., to financial intermediaries that hold no debt and consequently can’t go bankrupt? I’m talking here about money market mutual funds that have only shareholders, no creditors.

But why would depositors in systemically important banks fear for their money? After all, the government has, albeit reluctantly, told them they are fully protected. The answer traces back to the Nobel Prize-winning work of Douglas Diamond (University of Chicago) and Philip Dybvig (Washington University in St. Louis). The Diamond-Dybvig model captured mathematically what you see at the beginning of It’s a Wonderful Life – namely the potential for multiple equilibria.

Bear with me here. Suppose the functioning of the economy – whether it’s experiencing good or bad times – depends critically on what people think other people are assuming about how well it’s functioning. Then the economy can suddenly flip from good to bad times if everyone comes to believe that everyone else has changed their minds. In this hypothetical economy, it’s very costly to be the odd man out. Hence, everyone will flip if they think everyone else is flipping. This is why many multiple equilibria models are often called coordination failures.

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To make this more concrete, suppose the economy is perking along nicely, but that everyone gets spooked over some news. An example here is the collapse of Lehman Brothers in 2008. Then each firm may lay off its workers because it thinks other firms are doing so. And since one firm’s workers comprise other firms’ customers, laying off other companies’ customers because you think they are laying off yours is the individually optimal – but collectively disastrous – thing to do.

No wonder President Roosevelt said at his 1933 inauguration, “The only thing to fear is fear itself.” Roosevelt’s assessment of the Great Depression holds equally well for the Great Recession. Indeed, my own 2019 Milken Institute Review article makes the case that the Great Recession had no economic basis apart from collective panic.

All banking crises feature multiple equilibria. In one scenario, Jimmy Stewart sounds unconvincing, no one believes him and everyone demands their money immediately. As a result, Bailey Brothers Building and Loan fails, and Bedford Falls becomes a ghost town. In another, Jimmy Stewart convinces everyone to coordinate their behavior on the good equilibrium and leave their money on deposit. Bedford Falls thrives.

Are Federal Deposit
Guarantees a Joke on Us All?

The FDIC is out of money. Really. It had very little compared to its potential liabilities – $128 billion in a system with trillions at risk – before SVB failed. It used what it had to cover the depositors in the three big failures. Thus, at least in theory, if uninsured depositors yank their remaining $7 trillion or so in uninsured deposits, there would be no backstop. Note, moreover, the depositors who collectively hold $10 trillion in “insured” deposits would hardly be in better shape since the FDIC’s cupboard is bare.

This, I would argue, would also trigger a run on the $6 trillion or so in “cash surrender policies” – policies that guarantee liquidity – that are the liabilities of life insurance companies. Hence, we’re talking about roughly $23 trillion that somehow would need to be covered by insurance to prevent the financial system from imploding. But since the FDIC is itself penniless, the Federal Reserve would need to “print” trillions to save the day.

Or not. I believe that creating so much money would trigger expectations of hyperinflation. The fear of inflation would cause anyone with money in the banks to use it to buy tangible things – real estate, commodities, etc. – that would retain their underlying value. Alternatively, they could invest in equity- financed mutual funds, i.e., in financial intermediaries that aren’t vulnerable to bankruptcy because they have no debts.

In short, the government cannot insure the uninsurable – namely, what economists call aggregate shocks, including collective panic. Thus, at the heart of the problem of government guarantees is the problem of multiple equilibria that include uninsurable scenarios. Smart uninsured depositors, even those whose money is parked in systemically important banks, should be thinking about this.

In short, Dodd-Frank was based on a misconception. It fundamentally works by limiting the amount banks can borrow without equity backstops. But you can’t be a little bit leveraged any more than you can be a little bit pregnant.
Banks are Built to Fail

How could the financial system have slipped into trouble so soon after a massive government rescue in the 2008 financial crisis and the passage of the Dodd-Frank legislation in 2010 that was intended to prevent a repeat? Dodd- Frank, you’ll recall, mandated intense government oversight of banks – my term for all leveraged (indebted) financial intermediaries. What happened to those stringent capital adequacy stress tests that would spot and fix troubled banks well before they began to fail?

In short, Dodd-Frank was based on a misconception. It fundamentally works by limiting the amount banks can borrow without equity backstops. But you can’t be a little bit leveraged any more than you can be a little bit pregnant. The stress tests in their most stringent form assumed that 15 percent bank capital would be more than adequate. This means a bank can borrow $1 and invest 85 cents of it at risk. Consequently, if the bank suffers a 15 percent or greater loss on its assets, the bank is broke.

Do we know any assets that aren’t capable of experiencing a 15 percent decline in value? The stock market fell 82 percent in the Great Depression, 50 percent in the dot-com bubble (in 2001-2) and 53 percent in the Great Recession.

Even government bonds with virtually no risk of default aren’t truly safe. Five-year Treasuries lost 21 percent of their value in just the past two years. House prices dropped 27 percent during the Great Recession. In short, the notion that banks can’t lose 15 percent of their assets is absurd. But the problem is far worse. The current banking system is built to fail not just thanks to its leverage, but also due to its opacity.

You Can’t Oversee the Unseeable

Banking’s original sins are leverage and opacity. Of the two, opacity is the worst: Bear Stearns and Lehman Brothers both had a lot of capital backing their liabilities in the days before they failed. But even if the regulators believed this was so, the market certainly did not. And in any event, given the opacity of financial accounting, asset values can fall dramatically based simply on a rumor that either the bank’s assets are worthless or that depositors and other lenders are pulling out. I’m not pointing any fingers here, but large hedge funds were/are in a position to spread these rumors after selling short the shares of the bank they are attacking.

Bear Stearns’s collapse is a case in point. Let me offer two personal anecdotes. On the Thursday before the weekend during which the legendary investment bank, founded in 1923, was sold for peanuts, I sat next to a Wall Street trader on a flight to Boston. He asked me whether I knew that Bear was going under that weekend. I said, no, and then asked how he knew. He showed me a text message indicating that a major hedge fund had pulled its deposits from the company. The implication was that a run was on.

The day before, Bear’s stock price was $61.58 per share. Four days later, the company was purchased for $2 per share by JPMorgan. Did horrendous news arrive in those four days to lower Bear’s assets by a factor of 30?

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This brings me to my other story, this one involving my then brother-in-law. Jim was a senior banker at JPMorgan. He was one of the small army of JPM analysts sent into Bear on Saturday morning of that weekend to figure out what Bear’s assets were still worth. I asked Jim how much he and his colleagues understood about Bear’s assets before they walked in the door. He said, absolutely nothing. I then asked him what they understood after spending 48 hours going through the company’s books. He repeated: absolutely nothing. The variety of assets with hard-to-measure characteristics that are held by banks is mind-numbing.

This is not just a problem with the Dodd- Frank stress tests. It’s the fatal flaw underlying all banking regulation. Complex, opaque, i.e., unverified and undisclosed, securities can be valued at X or 30X based on, apparently, what others think others think are their worth.

From Trust Me
To Show Me Banking

As Bob Dylan put it, “It’s doom alone that counts.” Our banking system is doomed. It will fail either gradually or it will fail overnight. Even the tech innovators at Roku will realize that traditional banking is unsafe at any speed. If we follow the money in the post-SVB world, we can see the future of banking. It’s not, “Give me your money and cross your fingers.” It’s put your money with financial middlemen who can’t go broke and are willing to disclose precisely how they are investing.

This is “limited purpose banking,” which I proposed in my books Jimmy Stewart Is Dead and The Economic Consequences of the Vickers Commission. The reform eliminates banking’s evil twins – leverage and opacity. LPB limits all financial corporations to one purpose: financial intermediation. It does so by requiring them to do one thing and one thing only – to issue 100 percent equity financed mutual funds. The mutual funds could be “open-end” or “closed-end.”

The industry could follow the Chicago Board of Trade’s example and set up a market for closed-end mutual funds to purchase mortgages, small business loans, commercial paper, etc.

Owners of open-end mutual fund shares can redeem their investment at the close of trading for their market value. If the fund managers can’t fulfill all redemption requests in cash, the would-be redeemers are given their proportional share of the underlying securities. Closed-end funds buy and hold assets, such as mortgages, and pay their shareholders the proceeds of their investments over time. They can’t be redeemed, but they can be sold to anyone who wants to buy them – presumably for a price reflected in the underlying value of the assets.

In the system I envision, mutual funds holding only cash would facilitate transactions. Investors could redeem their cash just the way they do now – at ATMs, by writing checks, or by using a debit card. (They would pay for these services.) Mortgage mutual funds (some already exist) would fund mortgages. Small business mutual funds would finance proprietorships and partnerships. Corporate bond funds (already here) would finance corporations. The list goes on. All insurance products could be sold via mutual funds.

Zero leverage is powerful stuff. Not a single one of the approximately 8,000 equityfinanced mutual funds in existence ran into trouble in the Great Recession. The only mutual funds that failed were money market funds that effectively leveraged their investments. They sold shares with a promise to pay back at least a dollar for every dollar invested. This was leverage – making a promise that can’t always be kept. Since under LPB money market funds would be valued at market prices, not book prices, a systemic financial shock would create no incentives for a run as occurred in 2008.

LPB Eliminates Opacity

I envision a new agency – the Federal Securities Authority (FSA) – that would hire private companies to perform all verification and disclosure services for the new unleveraged system. These companies would be limited to one client – Uncle Sam. Disclosure would be in real time. Hence, if you invested in, say, a closed-end mortgage mutual fund, you could check on each individual mortgage held by the fund, including any income changes of the borrower, changes in the appraised value of the home, and whether the borrower was late in their payments. (The FSA’s disclosure wouldn’t create privacy concerns because the particular mortgage and the property’s location would only be specified by zip code.)

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Open-end funds are highly liquid. But thanks to the FSA, the secondary market in closedend funds would be equally liquid since their holdings would be equally transparent. All it takes is letting people see exactly what a closedend fund is holding. Indeed, limited purpose banking would surely provide far more liquidity than the current system.

where we’re headed

It’s not possible to fully describe so revolutionary an approach to financial intermediation in a few pages. The key question here, I think, is why I’m convinced that traditional banking is a dinosaur on the verge of extinction.

The answer is simple: follow the money. It’s leaving traditional banks and moving to mutual funds. Note, moreover, it’s happening without the lead of public policymakers, whom I fear are compromised by the endless torrent of political campaign funds from the financial sector. Mutual fund companies can readily create cash mutual funds and make profits by charging fees rather than by leveraging assets. Consider, too, that the mutual fund industry could take the lead and establish the FSA without the help of government.

Finally, the industry could follow the Chicago Board of Trade’s example and set up a market for closed-end mutual funds to purchase mortgages, small business loans, commercial paper, etc. This would permit borrowers to receive the best price for their FSA-verified and disclosed assets and end the notoriously inefficient practice of mortgage and loan shopping. The mutual fund industry could also create money market funds that mark their assets strictly to market. Their marketing pitch: we guarantee the guarantee-able, not a fight over the leavings. And they could make clear to the public that the new mutual fund industry is built to last, not destined to fail.

Skeptical? Join the crowd. But keep in mind the alternative: more financial market failure that leads to more hardship and economic dislocation followed by noncredible promises to fix things for good. Someday, some way we just have to do better.

main topic: Finance: Banking