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April 26, 2009
What a weird and interesting idea
Hence, Limited Purpose Banking can accommodate credit default swaps (CDS) as well as any other risk product. But what Limited Purpose Banking won't do is leave any bank exposed to CDS risk since people, not banks, would own the CDS mutual funds.If such mutual funds sound revolutionary, they're not. Funds of this kind have been around for centuries. They go by the name "tontines," or systems of "pari-mutuel betting."
This is interesting, and perhaps better than our current regime. It amounts to replacing all the financial assets of the household with equity. That may reduce systemic risks quite a lot because all capital structures are flat. However, no longer can you tailor your asset portfolio of stocks, bonds, and derivatives to meet your particular needs. In this regime you'd just hold shares of these different vehicles, and you'd purchase your insurance from these various funds. In some frictionless setting this wouldn't matter. You'd have the Modigliani-Miller theorem holding and enough Arrow - Debru securities that this would give you the same insurance as before. But in our messy world of agency problems, transaction costs, and incomplete markets, surely many would be worse off.
Kotlikoff and Leamer are wrong that this would eliminate systemic liquidity risk. Perhaps much reduce it, but not eliminate it. Reducing banking system leverage to 1 removes most of the systemic risk. Financial market makers have to hold cash and shares in all these closed end funds in order to make a market in them. They can still go belly up or mess up trading, leaving assets without market makers.
Further, by structuring these vehicles as closed end funds you eliminate a lot of liquidation risk, but at the price of vastly increasing the costs of changing the number of units in the fund. But that's something that happens all the time in credit default and other derivative markets. That's an example of how this would significantly increase the average cost of financial overhead to reduce the costs when things get really bad.
These may be trades-off worth making, However, their piece doesn't make it seem as though there are any downsides to this approach.
Posted by OneEyedMan at April 26, 2009 8:55 AM
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