Forget Traditional Banks: Consumers Need Deposit-Only Institutions

The news reported Friday that 18 of the largest banks have been using loopholes in financial reporting to mask how much money they are borrowing highlights the danger Wall Street's power poses to society. As I wrote in a DailyFinance article last June, I struggle with the whole idea of institutions that take consumer deposits and lend them out.

What bothers me about the way the banking system is set up now is this: You and I put our money in banks because we want a safer place to keep it than under the mattress -- but that isn't what we really get.

Other than safety, all most of us want from our bank is for the money we deposit to earn a little interest, and for it to be easily accessible to us through ATMs and the credit card system as we go about our daily routines.

Unfortunately, banks today are designed to take our money and lend it out to businesses so they can buy machines or pay salaries, or to people so they can keep greasing the wheels of commerce. Banks make their money on the difference between the low rate of interest they pay us for our deposits and the higher rate that they charge businesses and consumers to borrow them. They survive if they earn enough of a profit from the difference between the interest rates to make up for the costs of writing off the loans that businesses and consumers don't pay back, plus the costs of keeping the lights on.

And therein lies the problem: It seems like every 10 years or so, banks get too eager to lend out our deposits, so they borrow too much money from the capital markets to make up for the difference between how much money we deposited with them and how much they want to lend out.

The Money Bankers Are Putting at Risk Is Yours

The result of all that overly ambitious lending is that banks end up with an excessive number of bad loans, and they have to write off so many of them that dozens -- sometimes hundreds -- of banks go out of business. Fortunately for depositors, the U.S. government set up the Federal Deposit Insurance Corporation, which charges the banks an insurance premium which goes into a fund used to pay back the depositors who had the misfortune of trusting their money to an irresponsible lender. But this just spreads the risk out to everyone: The nation insures those deposits, and when risky investments sink banks, the government covers depositors' losses.

One of these waves of unwise lending with consumer deposits crested in September 2008, and the resulting destruction in the banking system nearly sank the global economy.

You would think that Americans would get fed up with letting bankers get paid millions of dollars a year to take such risks with our deposits. But bankers give so much of their money to politicians and lobbyists that its virtually impossible to fight them. And despite the near collapse of the global economy resulting from the banks' bad decisions, bankers took home near-record bonuses in 2009.

That bankers are allowed to put our deposits at risk to earn those out-sized paychecks makes me think that consumers need a different system. I think it would be better to separate the deposit protection and lending functions into different institutions.

Consider the Money-Market Fund: No Loans, No Risk

There is already a kind of institution that has done an excellent job of protecting our savings: the money-market mutual fund. Money-market funds buy short-term government securities and sell investors shares which remain valued constantly at $1 a share. People with money-market funds can write checks on their accounts, but money-markets aren't connected to the network of ATMs that make bank checking accounts so attractive to consumers.

I propose that what America needs are Deposit-Only Institutions which combine the safety of money-market funds with the convenience of an ATM network. If there was a way for a Deposit-Only Institution to partner with a bank's ATM network without putting up our savings as collateral for the banks' risky loans, that would be the ideal solution. Otherwise, such institutions would need to charge fees or find some other way to finance the construction and operation of their own ATM networks.

There is one little problem with the Deposit-Only Institution concept. Without our deposits adding liquidity to the system, businesses and consumers would have far less money to borrow, and this reduced level of borrowing would crimp economic growth, since so much of our economy depends on short- and long-term borrowing.

The good news is that we already have a way for businesses to borrow money that doesn't rely on consumer deposits for. It's called the bond market and it provides two different types of financing: so-called straight corporate debt (in which a company sells bonds to investors) and securitization.

Bond Market Could Handle Corporate Borrowing Needs

Securitization is the bundling together of thousands of small loans and selling securities to investors based on the cash flows from those loans. Many types of loans have been bundled together, including loans to finance corporate inventory, loans to buy houses, loans to pay off credit card bills, and loans to pay rent on corporate offices.

Most of these borrowers take out loans from banks, which turn around and sell the loans to investment banks. The investment banks bundle them together, then get a ratings agency to put their Good Housekeeping Seal (a AAA-rating) on the resulting bundled security, which then gets sold to big investors.

During the last 20 years, the corporate bond market was split on average about 50/50 between straight corporate debt and securitizations. Between 1990 and 2009, the total issuance of straight corporate debt totaled $11.471 trillion, according to the Securities Industry and Financial Markets Association. This represented about half of the total corporate debt market of $23.045 trillion during the period, with the balance being taken up by the securitization market and convertible debt.

But the corporate debt market -- particularly the securitization part -- has taken a nasty tumble since it was one of the biggest contributors to the financial crisis. According to Dealogic, at the peak of the securitization market in 2006, the total value of asset-backed securitizations totaled $2.172 trillion, a figure that tumbled to $130 billion in 2009 and through the beginning of March 2010, had generated a mere $11 billion in transactions. The collapse of the mortgage-backed securities market which contributed so heavily to the financial crisis was the primary culprit in that decline.

Moreover, straight corporate debt issuance has also stumbled in recent years. After peaking at $1.128 trillion in 2007, corporate debt issuance fell 10% to $904 billion in 2009 and appears on track to grow slightly to $930 billion in 2010 if current trends continue.

A Modest, If Imperfect, Proposal

While the alternatives to banks for savings and business lending are large, FDIC-insured banks remain even more central to our economy. How central? At the end of the third quarter of 2009, America's 8,099 FDIC-insured banks held $7.415 trillion worth of loans and $9.1 trillion worth of deposits, over eight times the amount of bonds that corporations issued last year and roughly three times the $2.964 trillion sitting in money-market funds.

So it would take quite a bit of shifting to Deposit-Only Institutions before consumers could free themselves from the risk that banks will lend out their money and lose it to deadbeat borrowers. However, if all $9.1 trillion worth of deposits in banks went to money-market funds, that would leave many businesses unable to borrow money -- particularly the ones that can't access the bond market.

Perhaps if banks want to keep lending out consumer deposits, they should have to pay a much higher rate to depositors in order to compensate them for the risk they're taking.

But in a world where deposit-taking was mostly separated from lending, maybe we wouldn't need to have an FDIC to handle failed banks. It's a modest proposal that would make life much better for the average American. And by keeping the capital providers and their customers at the same level of sophistication, it would hopefully make all parties far more responsible.

Most important, such a banking system would limit the costs to society of failure, while protecting the savings of the typical depositor -- money which remains at risk as long as bankers can loan it out to borrowers, some of whom won't repay.