The banking industry has a problem.

When the economy is good, banks are flush with money and are willing lenders. Competitors make less than prudent short term decisions and bankers feel they must follow suit in the lemming- like pursuit of profits.

In recent years, the ability to sell off and package loans has let bankers take more risk because they no longer have “skin in the game.” Regulators have not been immune to permitting banks to take more risk. Thus they have lowered underwriting standards and have had banks reduce their reserves (often at the exact time when reserves will be most needed). Often political pressure at the top has lead to reduced oversight.

Then when the economy turns negative and banks lose money, banks reverse their easy money policies and reduce lending. Partly this is because they do not want to recognize bad loans. Additionally it is costly and difficult to attract new capital.

Bankers also become cautious so even when capital was available, few banks used the TARP funds to make loans to businesses. Other banks borrowed cheaply from the Federal Reserve and used leverage arbitrage to generate income. This was not the purpose of TARP or the cheap money policy of the Fed, but bankers became risk adverse and took their cue from the regulators whose field staff use of heavy regulatory hand gave a “go slow message.”

In short, the problems of the banks soon become the problems for business and the economy because capitalism thrives on the availability of money. When banks are ailing, loans are scarce.

This problem has been discussed and debated at recent Federal Reserve of Chicago Spring meetings, and numerous ideas have been explored to reduce the scope of the problem. It is not the purpose of this essay to discuss the positives and negatives of those ideas.

But there is a solution that warrants discussion. This is the contingent liability fund that the private mortgage insurance (PMI) industry has used for over fifty years.

The PMI industry is regulated by the states because it involves insurance. It could be used for banks and at the federal level.

The private mortgage industry insures the credit of homebuyers who do not have a 20% down payment. If a homebuyer defaults on a loan, the PMI company can either pay the difference between what was put down on the home or can purchase the home for the mortgage remaining. This approach is an incentive for the lender to do his due diligence. The contingency reserve structure and capital requirements recognize the unique catastrophic nature of mortgage default. Funds are placed in the fund tax free.

I am not suggesting the risk sharing used in the PMI industry, but mention it only because it allows those in the PMI industry to estimate risk.

The weakness of the contingent liability fund approach is not the reserves but imprudent investments made by insurance companies or banks. For example, two PMI companies did a joint venture with loans they never would have underwritten for coverage. A few years back, one of these PMI insurers was purchased by a large insurance company who had the PMI subsidiary invest in its own subsidies.

Likewise, we need to put a strict “cap” on activities that banks and insurers do that get them in trouble. AIG, for example, insured collateralized mortgage packages without reserving adequately for the risks they were taking (perhaps they knew this in advance which is why the “hide” this subsidiary in Great Britain). Banks have had severe problems when traders over reached and failed to divulge their mistakes until too late. Nick Leeson, for example, was a trader who took down Baring Bank.

Of course, we do have ways to protect the important banking system. FDIC guarantees most deposits, and government can be the “lender of last resort” when banks fail. But the approach I am suggesting ought to be considered since it can absorb losses.

Bob Chernow is Vice Chair of the World Future Society and President of The Tellier Foundation. He predicted the S&L/Mutual Bank failures and the Sub-Prime crisis.

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