How to Take Moral Hazard out of Banking

As Dubai World's default shows, the financial crisis is far from over. Surprise, surprise, among the creditors with the biggest exposure is Royal Bank of Scotland - a reminder that reckless lending by supersized banks was a global phenomenon. Taxpayers are entitled to ask for a radical reform of banking regulation to ensure they will never again have to foot huge bills for financial folly. So far, there is only one credible proposal.

In a recent speech in Edinburgh, Mervyn King, the governor of the Bank of England, called for "utility banking", which would limit banks to their legitimate purpose - financial intermediation and payment facilitation - as opposed to gambling with taxpayers' money.

It was a brave and important challenge to a status quo that institutionalises moral hazard and exposes governments to ruinous losses. True, the enormous bail-outs, loans and guarantees provided to banks helped avert a Great Depression. But they have also sown the seeds of another disaster. The contingent obligations, which Mr King called "breathtaking," total three-quarters of UK gross domestic product. The US figure is twice GDP.

The public views these as real rather than nominal commitments. But were push to come to shove, governments would have to print the money to bail out the banks, leading depositors to walk, trot and, finally, run to get their money to buy something real before prices skyrocketed. Already, currency and gold markets are worried about future inflation. The bond market could be next. If yields rise before inflation, real debt servicing costs could soar.

The question, therefore, is not whether we need utility banking, but what form it should take.

Some in the US favour a new Glass-Steagall Act to separate commercial from investment banks. The former would behave themselves and be protected, while the latter could do as they pleased but without government help. Others favour narrow banking, which fully backs deposits but leaves the rest of the system on its own.

But times have changed. Jimmy Stewart - aka George Bailey, the trustworthy banker in It's a Wonderful Life - is dead. His local bank, Bailey Savings and Loan, is owned by a conglomerate. As Bear Stearns and Lehman Brothers showed, investment banks are too big, interconnected and psychologically important to fail.

Thus, Glass-Steagall and narrow banking treat only a part of our financial tumour, leaving the rest to metastasize. Limited purpose banking (LPB) is the only credible cure. It transforms all financial companies with limited liability, including insurance corporations, into pass-through mutual fund companies. Limited purpose banks would process securities and sell them to mutual funds. They would not be permitted to borrow to invest. Hence, they would never face a run and never fail. Risk-taking would be done by us, the people, via our purchase of more or less risky mutual funds.

Mutual funds are, effectively, small banks, with a 100 per cent capital requirement under all circumstances. Thus, LPB delivers what many advocate - small banks with more capital. Will this work? It has. Unlike so much of the financial system, the mutual fund industry came through this crisis unscathed. True, the Primary Reserve Fund broke the buck by investing in Lehman and had to be bailed out. But under LPB only cash mutual funds (invested solely in cash) would never lose investors' principal. The first line of all other funds' prospectuses would state: "This fund is risky and can break the buck."

Under LPB all mutual fund investments would be fully and instantly disclosed on the web by the system's single regulator - the Federal Financial Authority (FFA). The FFA would verify the credit histories, income statements and third-party custody of all fund securities. It would also hire non-conflicted companies to rate the securities and value their collateral. This does not preclude private rating, but it provides the public with independent assessment.

Thus, a bank would process a loan or stock issuance application, send it to the FFA for verification, disclosure and independent rating, and then auction the security to its own and other mutual funds. Auctions would ensure individuals and businesses get the highest price for their paper.

Under LPB people would be able to use cheques, debit cards and ATMs to draw on their cash mutual funds. Insurance mutual funds would permit people to diversify individual and share aggregate risks.

The cost of preserving highly leveraged financial behemoths still has the potential to bankrupt governments and debauch their currencies, wreaking yet more damage to their economies. Limited purpose banking would prevent this. We hope that Mr King is not the only public official smart enough to reach this conclusion.

Niall Ferguson is an FT contributing editor and author of The Ascent of Money. Laurence Kotlikoff is professor of economics at Boston University and author of Jimmy Stewart Is Dead (forthcoming)