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Why 2015 Was a Bad Year for Banking Reforms

Dec 31, 2015

This year is ending the way it began for taxpayers without any sign of relief from the repeated burden of bailing out the banks during the financial crises and continued pressure to modify the Dodd-Frank Act in ways that favor bankers and lessen protections for taxpayers.

A year of continued concessions to the financial industry included: delaying a Dodd-Frank mandate that financial firms sell off bundled debt, known as collateralized loan obligations; exempting some private equity firms from registering with the Securities and Exchange Commission; and loosening regulations on derivatives. The recent requirement that banks increase their capital ratio to 16% or 18% in the next few years still leaves the taxpayer responsible for the remaining 80% of the losses.

Given that banks spend over $1 million per week on lobbying, is there any point in even raising the question of whether 2016 — a presidential election year — will be different? Judging from the past 85 years (since the Great Depression), it seems unlikely that politicians will begin to favor consumers over bankers who make plush campaign contributions.

So without proper, or at least more aggressive regulation, it is worth starting this new year asking the most pertinent question: What can we do to shore up our banking system? The answer is simple: replace some part of the current system with a non-bank alternative. Let me explain.

During the 1930s, after observing the total collapse of the banking system during the Great Depression, a group of economists at the University of Chicago, followed by Irving Fisher from Yale University, tried to convince President Roosevelt to separate deposit-taking activities from lending activities and to embed this separation into the 1933 Banking Act.

Two Nobel Prize laureates, Milton Friedman and James Tobin, later also proposed this solution. Economists often refer to the proposed structure as narrow banking because banks would be required to maintain 100% of depositors’ money in the form of cash or government-issued bonds, which are considered the safest assets. Both economists felt that more regulation was not the solution but that a change in the structure of the banking industry was. That continues to be true today.

However, since it is clear that in the current political climate, banks cannot be regulated without great difficulty, one feasible remedy would be to gradually replace traditional banking with non-banks that provide bank-like services.

Some examples of these non-bank service providers already exist. Consider companies, such as: PayPal, Venmo, Square Cash, Stripe, Dwolla, Walmart's Bluebird Card, Green Dot, Target's REDcard, and even Bitcoin (virtual currency). All these provide bank-like services at low cost to consumers with no risk to taxpayers because all transactions are prefunded by the payer.

On the lending side, companies, such as the LendingClub, Prosper, Lend Academy, CommonBond, and Crowdfund Insider, already provide loans with no reliance on taxpayer money. This new industry is often called FinTech (Financial Technology) because it provides superior financial services that utilize cyberspace at extremely low costs compared with traditional banking. Recognizing the importance of this growing industry, MIT now offers a course on FinTech. Similarly, FinTech clubs, such as MIT FinTech Club and Wharton FinTech, are trending at business schools, according to the American Banker.

Currently, non-banks that provide bank-like services are at a competitive disadvantage because they must obtain separate licenses and adhere to different regulations in each of the 50 U.S. states. In addition, they must deposit unused balances with traditional banks and pay fees. More importantly, FinTech companies do not have direct access to low-cost services provided by central banks, and therefore must settle their transactions via commercial banks.

A simple way to overcome these obstacles and to encourage competition with established banks is to allow non-bank financial service providers access to the same services that banks currently receive from central banks. Just like narrow banks, because the transactions performed via these service providers are prefunded, they maintain 100% cash reserves and therefore pose no risk on the system.

Given that it is unlikely that politicians will introduce necessary structural changes in this election year, perhaps the best way to judge 2016 would be to watch whether both Congress and central banks recognize the importance of FinTech and facilitate its entry into the marketplace even if banks intensify their lobbying activities to block these promising financial developments.

Oz Shy is a Sr. Lecturer teaching economics at MIT Sloan School of Management. He has published three books: How to Price, The Economics of Network Industries and Industrial Organization: Theory and Applications.

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