Wednesday, September 24, 2008

Are banks obsolete?

Posted Sep 20th 2008, by Peter Cohan

The Federal Deposit Insurance Company (FDIC) insures the deposits of 8,400 banks in the U.S.. But I wonder whether their costs to society outweigh their benefits. Maybe we should replace banks with a system that protects our deposits and keeps them out of the hands of bankers.

Banks made sense when people needed to protect their checks and currency from thieves. By depositing them in banks, people got physical protection of their money. But they paid a hefty price. That's because the banks took most of the cash -- keeping a sliver on hand -- and used the rest to make money for themselves by lending it out to other people. In exchange, the depositors got a small interest payment -- but one that was far lower than the profit that banks made on the loan.

But giving away profit to banks is not the only cost society incurs for letting them operate. We also pay for their mistakes. In less extreme credit contractions, we pay through declining value in our retirement accounts to the extent that bank shares lose altitude as their credit losses mount. And now, thanks to the current financial crisis, we pay by using what could amount to $2 trillion to keep the financial system afloat. And that's all because we allow banks to operate recklessly -- keeping the profits they earn in good times for their employees and shareholders and, when they collapse, outsourcing their losses to taxpayers.

What if, instead of using banks to safeguard our deposits, we let each person keep their money in electronic form? Companies might spring up to keep track of the inflows and outflows from each person's account -- these companies might merge the functions that banks currently perform in keeping track of accounts with that of credit agencies who rate the credit of people and companies.

People would use a smart card or their cell phones to spend money and companies and individuals could electronically deposit funds to the database. A government agency could monitor these companies to assure the accuracy and timeliness of their work. People could then make their own decisions about how to invest their money rather than letting bankers decide who to lend it to.

If banks wanted to continue to operate, they could get their money from other sources -- such as the bond market, the stock market, or institutional investors. But if they failed, they would not threaten the deposits of consumers and businesses as they do now. Ultimately surviving banks would be the ones that made money for their institutional investors.

But their operations would be less central to the functioning of the global economy because they would not be using consumer deposits to fund their risky bets. And thus we would not be at their mercy for our survival as we are now.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.