Thursday, December 11, 2008

New Banks - A Pragmatic Solution

I would like to offer a pragmatic solution to the underlying problem of the current crisis: the creation of completely new banks, unrelated to all the current ones. As I wrote in my most recent post, I believe that the true cause of the economic crisis, and coming depression, is that the financial industry has spun itself off from the financial economy and created a shadow economy, what I called the “third economy”. The third economy is hidden from everyone, including Wall Street investors and banks, and is made up of the types of assets that we now know all too well, such as packaged sub prime mortgage securities. The third economy sold this to everyone, in one way or another, and spread its “assets” around the world. The third economy was able to coat crap with gold, funnel enormous amounts of money into itself, and create a global crisis.

The reason that new banks have to be created is that all the current banks are contaminated by the third economy, as if they had been contaminated by radio activity. Write-downs of assets, marking toxic assets to “market” (I put that in quotes because there is no market, and hence the assets are worthless), or any other market function does not even come close to correcting the problem. If you’ve been contaminated by radio activity you’re supposed to take a shower, but that won’t stop your cells from disintegrating.

The TARP plan was meant to accomplish something similar to what I am proposing, but again, because of the scale of the problem, all such efforts are futile. In theory, money from the TARP plan would take all those assets away from the banks and create a new, shiny bank. Another idea has been to a create a “good bank - bad bank” solution, which would accomplish the same thing: an untainted financial institution we can all trust. However, that cannot be done because the situation is far too serious as of now.

In no way is this solution a creation of my brilliant mind - it has been used before. Dennis K. Berman recently wrote in the Wall Street Journal about this, and provided a historical context. The first Bank of the United States was created under Alexander Hamilton in order to instill confidence in the financial system. The second Bank of The United States was created in 1816 specifically to deal with a currency crisis. The important thing to remember is that confidence in the financial system is evaporating quickly, and we have to do something about that. With the help of the U.S. government, new banks can be created, with new people running them, and we can partly start with a clean slate. The old banks will have to continue to struggle, and if they survive, it will be because they can free themselves from the shackles of the third economy.

The following is a simple explanation of how this could be done. Instead of spending money on contaminated banks, the government should sponsor the creation of new banks directly. Let’s say the government creates “The New Bank”, and injects $20 Billion into it that can be used to lend to the public. The creation of The New Bank would be coupled with strict regulation in the bank’s charter with respect to leverage ratios, lending standards, codes of ethics and the like. By putting it in the charter of the bank itself, a lengthy legislative process can be avoided. The U.S. government could also implement an “investment matching” procedure, meaning that if a private investor invests one dollar in The New Bank, the government could match that.

All this would create instant confidence on the part of the financial market in this new, clean and dependable bank. Also, this type of investment actually has a very great potential of making taxpayers money, as opposed to all the other bailout attempts that had absolutely no prospects of even breaking even at any point in the future.

Furthermore, new banks with prudent standards and well-capitalized business models would necessarily create a new standard in the industry, which would enhance the stability of the American economy in the future. At least until the next wave of deregulation comes along…

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