The Cure for the Banking Industry, Part II: More Private Capital, Less Public Risk

In my previous post, I outlined several strategies our government can take to stop the Federal Reserve from constantly manipulating the value of the dollar, which has wreaked havoc on the economy. Recognizing the political climate, here are six ways to mitigate the risk of economic ups and downs until a deeper monetary reform is viable.

Require banks to have substantially more capital. This would shift the risk from the taxpayers to the shareholders. The additional capital requirements would be phased in over 5 to 10 years. Banks should have at least 20 percent shareholders'equity in relation to risk-weighted assets.

Eliminate FDIC insurance (or at least reduce it back to $100,000). FDIC insurance destroys market discipline. As an alternative to FDIC insurance, create a private insurance pool, with private companies, not government bureaucrats, managing the risk. While this would not be optimal, the private insurance pool might be allowed to purchase, at a market price, catastrophe insurance from the federal government until confidence in the pool has been established.

Make it explicitly clear that the Federal Reserve cannot save nonfinancial institutions. If you buy GE or GMAC commercial paper, the risk is yours. Banks cannot operate with a strong capital position if their competitors (GE Capital, for example) are implicitly protected by the federal government.

Eliminate 90% of the regulatory burden and related social policy burden placed on the industry. The banking system should not be used to hide the cost of Congress’s social programs.

While Congress should not be allowed to subsidize housing, if it is going to do so anyway, at least the subsidy should be transparent. Many banking regulations are actually social subsidies that are unconstitutional and whose costs are hidden from taxpayers.

A very significant part of the noninterest expense cost structure in a typical commercial bank is directly or indirectly related to some form of regulation. Banks cannot make acceptable economic returns on the increased capital with the current massive regulatory burden. Many of these regulations result in destructive economic investment (affordable housing being the prime example) and thereby reduce the long-term standard of living. Banks should make investment decisions based on rational economic analysis, not politics. If politicians want to subsidize favored groups, let them do so directly.

The Fed must not have the authority to save money funds. Money funds claim to be less risky than bank deposits. The financial crisis proved that they are more risky, but the Fed bailed out the money fund investors. Banks cannot compete pricewise with money funds that take more risk and pay higher returns, but claim not to be taking the risk.

Privatize or liquidate Freddie Mac and Fannie Mae, and close the Federal Housing Administration. The political risk in these organizations is tremendous, as witnessed by the affordable-housing bubble. At a deeper level, subsidizing housing does not make economic sense. I will elaborate on this in my next post.

All six components just outlined must be fully executed for this program to be viable. Piecemeal execution will not work. Banks cannot be required to raise their capital and still carry the regulatory burden.

If we do not deal with the issues raised here, there will be another incredibly destructive crisis in our financial system in the next 10 to 15 years. Without structural change, the lessons from the current financial environment will be lost. We need structural change to make freer markets, not more tinkering at the margins.

John Allison is the president and CEO of the Cato Institute and the former chairman and CEO of BB&T. This article is adapted from his forthcoming book, "The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy’s Only Hope."