Tuesday, May 26, 2009

A New Banking System

The current crisis made us realize how financial sector in general and banks in particular can hold the economy hostage. The crisis was precipitated by a credit freeze triggered by fall of Lehman Brothers. As a response Fed kept pushing money into the bank but none of it reached the deserving households or small enterprises. So we know we need a new Financial system. Mike has a nice post about The financial sector we want.

Rethinking banking - Banking as water management system
We can think of banking as water management network. We have water reservoir, the piping and usage meters, then we have used water drainage, used-water treatment and back to other reservoir. The used-water is savings that feed into the reservoir - bank deposits. The worst part of banking crisis was the looming disappearance of the the piping and drainage network.

Now, the network needs to be as big as possible, bigger the better. A larger network means accessibility across the country / world, it means freedom for the consumer. It means the network will be operated like a utility company, with very small fee and highly regulated operation.

The reservoir however, needs to be small enough to be manageable. And more the merrier. Here replacing one by other will ease the strain on the economy. In radical times, Fed can directly be the money reservoir and plug itself into the system.

Tomorrow's Banks = Today's banks - Banking infrastructure "system"
So we are looking at splitting banking into three parts - financial infrastructure system, deposit taking institutions and loan making institutions. While, the last two can be same, they cannot ever be infrastructure. Glass-Steagall Act achieved this in smaller degree. I think, looking at recent experience, it makes sense for the financial infrastructure to be government owned. At least, it needs to be heavily regulated large utility like power transmission company or water supply company. Alternatively, it can be a well-designed Internet based system as well - then no need for any company.

What is financial infrastructure system?
The role of financial infrastructure company will be that of a conduit. Citizens will have an online account, with a free (zero fee+ zero charge) debit card. It will allow the citizen to login and allocate his/her savings to deposit-taking-institution of choice that can manage it with promise of interest income. The system will collect a fee from deposit-taking-institution as an insurance against insolvency of the institution. The amount of fee retained will depend on rating of the institution.

Further, lender (including credit card providers) can lend to citizen based on report generated by system. These reports will protect privacy as per legal guidelines and give information enough for processing creditworthiness test. It may also generate a FICO-like score for the borrower. Lender, once satisfied, can be plugged into citizen's account. The system will schedule and process payments or at least set alerts to prevent defaults.

Privacy and prudence
The suggestion also raises privacy and government intrusion concerns. I am not sure I understand all the problems that may arise in such scenario. However, it is definitely an idea worth exploring.