Is it time to end speculative banking on the taxpayer's dime?

In the weeks ahead, righteous indignation may resurface as taxpayers get wind of how Wall Street bankers pay themselves multi-million dollar bonuses, subsided by the public.

Is there a better way? One that produces policies that achieve the common good, while still retaining the benefits of the free market system? Indeed there is. And it doesn't involve banning banks or limiting their involvement in the economy.
Arguably, the problem is not banks per se, but the abuse of FDIC rules and related insurance protections. And what has to change is not banks themselves, but the rules that create an environment in which heads the bank wins, tails the U.S. taxpayer loses -- and pays.

Economist Richard Felson told DailyFinance he's in the camp that argues banks have taken advantage of depositors insurance and federal support for banks, among other factors. "I'm not saying that all banks and thrifts operate this way, or all the time, but the sad fact is that, for the better part of a century we've seen this cycle of overly aggressive lending, followed by government bailout, followed by aggressive lending or lending that skirts the rules, followed by bailout," Felson said. "And this latest bailout, for bad bonds, questionable securitization schemes, and mortgage defaults, has been massive. The public debt service requirements and burden on the taxpayer will be with us for decades. And the taxpayer has reached his or her limits."

However, what the U.S. cannot do, Felson says, is eliminate depositor insurance as "it's one of the bedrocks of depositors' faith in the system."

One viable solution, Felson said, is two-tier banking. Briefly, Felson argues that there should be two levels of banks.

Tier one: private banks that invest in commercial operations, offer higher interest rates and have other exotic investment products, but offer no government insurance on deposits.

Tier two: community-based banks that invest primarily in conventional mortgages, offer very low interest rates on deposits, have no high-risk/high interest rate investments, but offer government insurance for depositors.

The community banks would also feature below-private-market salaries for executives, perhaps supplemented with a portion of benefits paid by the federal government. "But there would be no $500,000 per year executives in these banks, only modest executive salaries," Felson said.

A good portion of the banking sector will be transformed back into the low-growth, boring but safe sector that it's supposed to be, with low executive salaries. It other words, it will return to 3-6-3 banking: Pay three percent interest, charge six percent interest, golf at 3 p.m.

The advantages of the two-tier system? There will be fewer, costly federal government bailouts, Felson said. The private banks could continue to invest in speculative, vacation condo complexes in suburban Las Vegas, it's just that when those projects fail, it will be on the stockholder's dime, not the taxpayer's.

Banking sector analysis: One can make a strong case for a two-tier banking system. There's nothing wrong with a bank paying nine percent on deposits so that it can loan the money out for a speculative mortgage for luxury condos in Las Vegas. It's just that in the future, you as a depositor will know that you could lose every dime in that bank.

Meanwhile, the insured banks will pay a much lower interest rate on deposits, but those depositors will know their money will always be there.

We want banks to take deposits, lend, process transactions, create wealth, and perform a myriad of other functions that have helped economies grow for hundreds of years. What we don't want is bank losses and recklessness paid for by the U.S. taxpayer.
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