A New Goal For TARP Money: Create Mutual Banks
Call this a wild idea, but if the government wants to leverage its efforts in encouraging credit in the US economy, it should consider seeding mutual banks. The US government would contribute money to 435 new banks (say $250 million to each), one for each congressional district, with the provision the government’s stake could be bought out at 1.5x what it put in. The government would have a preferred dividend of 3 month LIBOR plus 5% or so.
The mutual banks would attract deposits, because the institutions would be healthy. WIth the leverage from deposits, these new mutual banks would make loans that many current lenders would shun because their balance sheets are compromised. They would be smaller institutions, not large like Fannie, Freddie and the FHLBs. Depositors would own 2/3rds of the banks, with the government’s preferred stake getting 1/3rd of the votes. These banks would pay dividends to depositors above any interest paid, in proportion to the profit earned on balances deposited. (CDs being a higher cost source of funds would not get much of a dividend.) The dividends would be paid out of profits in excess of what is needed to maintain the bank’s capital levels.
The mutual banks must remain mutual for 10 years, after which, they can be demutualized, with shares going to existing depositors in proportion to the cumulative profit earned off of each account for existing depositors.
That allocation system, similar to what is done with mutual insurers (”the contribution principle”) solves a lot of problems: people rushing to deposit when they hear about a demutualization, or, small depositors that think they will get a biggish slug of stock. Sorry. This is yet another area where the insurance industry is a lot brighter than the banking industry, and why? We have actuaries, and you don’t. 
Actuaries are the best kept secret in business, at least, that is what the Society of Actuaries tells me. This insures fairness in who gets equity, and how much.
Now, this provides a much sweeter deal to depositors than what they currently have at their banks. It is almost as good as a credit union, except these are subject to taxation. (As the credit unions should be.)
This raises the objection: what of our current banks? Will you let them go bust? Why not prop them up?
This is one of the stupidities of how the current TARP was set up. We reward incompetence. Better we should allow the institutions to fail, wipe out the common, preferred, sub debt, etc. After that, transfer the deposits and clean assets to the new mutual banks in the vicinity, and let the FDIC reconcile the crud through a new RTC.
This would set the incentives right. Failure gets punished. Depositors get rewarded for depositing in healthy institutions. The government makes no big promises, but the interests of depositors are protected.
This puts the stick in front of existing banks. No handouts, and more competition. Show that you can delever and deliver, and you will survive. Aside from that, we consolidate the failures into new healthy institutions. With big failures the FDIC kicks additional funds into the affected mutual banks absorbing problems, but with an increased ownership interest to be bought out.
This is my idea of how the government and private industry could cooperate, with low ultimate costs to the taxpayer, while not subsidizing incompetence. Such a deal. Should I send it on to the Obama Administration?
January 10th, 20097:16 am at
…..Should I send it on to the Obama Administration?…..
YES, ABSOLUTELY.
January 10th, 20099:52 am at
Send it along, no question. Shedding the hideous concentration risk in the system would be a huge positive. I just grind my teeth when I hear of one of these “too-big-to-failers” using TARP funds to buy other banks. It should work the other way around.
And we’ll need something in place for the day when we finally recognize today’s behemoths are actually insolvent entities.
January 10th, 20091:42 pm at
This is a good idea; and I think you posted an idea of offering US citizenship to individuals/families that buy a home minimum $300,000 in cash. What the heck; give them tax breaks for 10 years; we just rebablanced global trade!! This idea would really work too.
January 10th, 20093:37 pm at
Brilliant…absolutely brilliant. This is the best banking idea I’ve heard during this mess. Send it to everyone. Since Paulson, the ultimate slave to Wall Street, is leaving it could actually have a chance. The big banks would fight hard to kill it, but this is a plan I would think Dems would love. I’m fiercely Libertarian and even I like the plan (since we’re going to have some sort of plan anyway…might as well be a sensible approach).
Nice work David.
January 10th, 20093:59 pm at
Yes, definitely send the idea. I like it primarily because it would reduce fear among depositors. People are becoming more afraid each day as they learn of lost investments, endangered savings, job cuts and home foreclosures. We are a fear based nation right now, and fear diminishes our resilience.
Many thanks for the blog; you help a lot of people with your writing. Clear, honest information gives people hope and confidence.
Best wishes,
RP
January 11th, 200912:10 am at
What’s the minimum you need to start a bank? I mean, you or me. Or you and me? Barriers to entry in lending are practically zero, everything is based on trust.
Can I form a bank holding company in Delaware, and seek TARP funds with the explicit purpose of lending?
How about I solicit Grameen-style groups of 5 for microcredit loans? Consolidate your debt with your neighbors and in-laws.
January 12th, 200910:10 am at
I may be mistaken, but there are already 1,000’s of mutual S&L’s out there – one to three branch banks that were started with a slug of private capital, but are essentially owned by depositors. In fact Peter Lynch put the spotlight on these institutions in the early 1990’s, because depositors got a great deal when they demutualized.
There is another brand of mutual bank out there that is doing fine – credit unions.
January 12th, 200911:34 am at
David, this is a very interesting proposal. I like the incentive message it sends, the way it helps to diffuse the big issues rather than setting us up for an even bigger disaster next time with “way too big to fail” institutions that the governments aren’t able to recapitalize, etc.
My one fear is that this would create an enormous initial shock to the system. The write-off of all bank investments would be an exogenous shock unlike any our economy has ever experienced. I understand your views from the past that institutions’ capital structures should be such that they can withstand shocks, but the black swan nature of what you’re proposing would likely rock every industry with any mildly fixed cost structure. Foreign banks would fail as well, forcing their governments’ hands into either similar or other unpredictable reactions. What would you recommend the transition to such an end-game look like?
Thanks, as always, for a very thought-provoking post.
January 14th, 200911:36 am at
A refinement to make it a better idea, IMO, would be to further require a separation into “deposit taking” instiutions and “lending” institutions. There is no reason they have to be married together. Further the “deposit taking” institutions should effectively offer mutual funds (mainly money market) where all the investment risk is borne by the customers. These “deposit taking” institutions essentially compete based on expenses. The “lending” institutions would underwrite loans and package them up into funds (to be invested in by customer of the deposit taking institutions amongst others) but the “lending institutions” would be require to retain a significant first loss position on everything they underwrite (this being their capital requirement). Distinct and appropriate regulation would apply to each institution with a focus on “skin in the game” for the lending institutions and “disclosure of fund risk profile” for the “deposit taking” institutions. Governments could provide different safety nets to the two institutions. Ancilliary banking activities like derivatives would be moved to other types of financial institutions and regulated such that their potential insolvency does not jeopardize the lending and deposit taking institutions.