Volcker's Vision of a Return to Narrow Banking

While this might seem nihilistic, Volcker has a point. Banking "innovations" are a lot like grandiose, state-based welfare: all it seems to do is cause waste (enriching middlemen) and further separate people from each other, undermining meaningful connections to individuals and communities that are an essential part of human relationships. Does anything illustrate this more perfectly than a system where loans were pushed on those who couldn't really afford them, often with fraud added, because they'd be sold off to a bank that wasn't going to hold them (collecting another fee), going to an investor who was deceived as to the nature and risk of the loan and was half way around the world anyway? Contrast this to a situation where the local banker extends an appropriate loan to someone he knows from his community; both to help them and to help the bank (because the bank is going to hold the note forever). Is it really possible to "improve" on this?

"But", financial innovators will say, "our system is so much better because it allows banks to 'free up capital' that would otherwise be 'dead' because they would be sitting on the loans." We could "fix the problem" by making sure that originators and securitizers retained liability for their actions, just as if they were holding the loan to portfolio.

Ignoring for a moment that much liability was retained -- remember that the independent mortgage lenders started collapsing when they were forced to buy back relatively small numbers of early-defaulted loans -- there is something fundamental that bugs me about this mindset.

The nature of a loan is that you sacrifice some of your wealth today, so that it might be put to productive use by someone else, and if all goes well, you have increased both your wealth and that of someone else down the road. But you might lose it, and during the loan period, you don't have use of it. In other words, its a sacrifice on the part of the lender. If it isn't a sacrifice, why should there be any reward? Why should the arrangement even be expected to work?

The truth is, it shouldn't. In the system we have (had), there was no sacrifice. Banks didn't want to give up any of their capital today and wait for the results. So the securitization and derivatives complex was invented. But you cannot create more capital out of nothing (except gainful investment, and securitization fees don't qualify), so they simply increased leverage instead. And accordingly, the gross leverage of the entire financial system skyrocketed under this regime. And the authorities sat by silently, or even approvingly, throughout this whole era. In essence they approved of a complete fiction; a financial perpetual motion machine where somehow credit (leverage) could substitute for capital, and it was presumed that wealth would be created as a result.

I am with Volcker. If this crisis constitutes the end of that system, it would be a very good thing.

-apk