Friday, April 18, 2014

Banking Reform

Thomas Piketty’s book Capital in the Twenty-First Century has been getting a lot of attention lately. I can easily to add it to the stack of books that I want to read. Actually reading it: maybe someday! Somehow a serious book like that takes me a month. There are just more books to read than months to read them in!

From the various reviews and discussion I have seen, the basic points of the book seem to be: when the rate of return on investments is larger than the rate of growth of the economy, wealth disparity grows, eventually to problematic levels; an effective method to address this problem is by taxing wealth.

I think the diagnosis is reasonably accurate. While there are also other mechanisms by which wealth and power amplify themselves, this financial one is surely very important. But I am not enthusiastic about his proposed therapy. It treats the symptoms without getting to the cause of the malfunction. On top of that, such tax revenue too easily becomes another concentration of wealth and a target for further corruption.

The cause of the problem is that returns are not tied to growth. This is due to the way financing is structured. The way to fix the problem is then obvious: restructure financing! Of course this is not so easy. First, one needs to design some alternative structure. Then there needs to be some sort of transition to take us from today’s structures to tomorrow's. And finally all this needs to be presented in a way that the various parties involved can agree to enact the plan. These are all daunting challenges. Into the fray!

Don’t start punishing the rich; instead, stop punishing the poor! This is my proposal in a nutshell. Perhaps this medicine will bitter for the wealthy, but not as bitter as the alternatives that might otherwise be forced on them! To some degree the pain can be lessened by a gradual introduction of new structures. New structures can be introduced alongside the existing old structures. Whatever kinks appear can be worked out over time. New financial contracts can start shifting over to the new structure. Most contracts that use the old structures can just expire in their normal time frame. Some long term contracts may need to be translated into new structures, but by then the new structures should be well established and well understood so the cost should not be prohibitive.

The best way to build new structures is to adapt existing structures. We already have many different financial structures: means by which one person can use resources owned by another and share the benefits yielded by that usage. Fred can borrow $100 from Joe, enjoy the use of that money, and then pay Joe back $110 a year later, rewarding Joe with a share of that enjoyment. Alice can grow vegetables in Mary’s plot, and at harvest time share the bounty with Mary. Bill can fund an expansion of Sam’s workshop, taking part ownership in the business, and with that a share in the profits and in the decision-making process.

Two classical financial structures are stocks and bonds. They are both ways that someone with some money to spare can make that money available for someone else to use, in exchange for a share of the benefits gained by that use. The return on a stock investment is often quite uncertain. It can come in the form of dividends or by the capital gains accrued when the stock is later sold at a higher price. Either way, there is quite a bit of administrative overhead involved, in establishing dividends or a market for stock trading. A bond is much simpler. It is basically a loan but without a bank playing an intermediary role. A bond contract generally specifies a definite repayment plan, like a loan. Bonds can be traded too. They differ from stocks in several ways: they have a fixed time span, the dividend rate is fixed, and they don’t include decision-making power.

A typical bank loan is very much like a bond. My proposal is that bank loans should look more like stocks. The dividend rate should not be fixed, but coupled to the actual performance of the borrower. What is needed is some standardized structure in banking laws and regulations to cut the administrative overhead to a bare minimum, so this can be managed effectively in the banker-borrower relationship.

Similarly, the relationship between the bank and the depositor needs some adjustment. The notion of risk-free returns is an illusion that is too expensive to maintain. A bank’s business should look like a collection of mutual bond funds. Depositors become instead purchasers of shares in these funds.

The core principle I am proposing here is that loans be tied to increased income. In other words, loans for consumption would not have a place in the laws and regulations for banking. If you need a car to get to work, then it makes good sense for a bank to lend that money. If you want a bigger car because it is fun to drive, you’ll have to save your money up first!

Loan repayment should be tied to income. Just like corporations with publicly traded stock must publish financial statements, so must bank borrowers. Since most people file income tax returns already, perhaps the easiest way to minimize administrative costs is to integrate income tax accounting with bank loan accounting. These systems are already closely coupled, so it shouldn’t be too impractical.

In general, a person will have several outstanding loans. So the core question is: given a particular level of income, how should dividend payments be computed? The idea is that each loan includes in its terms a formula for computing dividends, taking into account both income and pre-existing loans, taxes, etc. For example, a loan’s payment could be determined by a formula like: given the borrower’s total gross income, subtract all taxes due and payments from all earlier loans; subtract also a standard inflation-corrected minimum cost of living for the borrower and dependents; from what remains, the dividend due is 20%. The terms should also include some time limit.

Of course the dividend rate depends most fundamentally on the amount borrowed, obligations from earlier loans, and expected income. There are lots of tricky corners. A car loan might be negotiated on the basis of an existing house loan. Perhaps the borrower needs to move because of a job relocation. Paying off the existing house loan and negotiating a new house loan could change the order of loans and create havoc in the simple structure I have outlined. Perhaps the existing house loan can simply be shifted to a new house. Tying the surety of repayment to verifiable income, rather than the threat of foreclosure, should clear the way for this process. In any case, it is not fair to lenders if later loans can reduce the return that had been negotiated but also not fair to borrowers if repayment of earlier loans unduly increases dividend payments to later loans. To develop standardized structures that can navigate these passages is not trivial but surely possible, especially with an incremental approach.

Financial regulations are obviously vast and complex. My main point is that it is their structure that decouples returns from growth and that serves to amplify the wealth of the wealthy and the poverty of the poor. Rather than tacking on new structures to counteract this amplifying process, quite practical structures are possible that simply avoid this bias. Rather than stealing from the rich, stop stealing from the poor! The ruin of people’s lives due to snowballing debt is just as destructive to the healthy functioning of society as burdensome taxation that suffocates success. We can build financial structures that tie the success of lenders to the success of borrowers, so that free market capitalism promotes productive investment and discourages exploitation and abuse.


  1. Why money is legally issued as loan (credit) by centralized private commercial banks and not by the people and their choice of free and fair financial structures like decentralized public and community banks?

  2. Yeah it would be interesting to know, what does it take to start up a bank? Certainly there are banks that are local at the scope of a few counties or so.

  3. Ah, here is someone proposing very much my scheme, though at the national rather than individual level.

    "If Greece does X, Y and Z, then the creditors will guarantee the debt-to-GDP ratio will decline to some number in 3 years. If the economy grows, great. If not the creditors would take a large write-down."