It's time for two-tier banking

By Money Matters Editors

U.S. Sen. Banking Committee Chairman Chris Dodd’s plan to rein-in bank executive compensation and bonuses is barely a week old and already it’s being called ineffectual.

“For the most part it’s pretty hollow, a toothless tiger,” said Paul Dorf, managing director of Compensation Resources Inc., a pay consultant based in Upper Saddle River, New Jersey, told Bloomberg News Tuesday. He added that the legislation needs more penalties if the rules aren’t followed.

Perhaps the problem is not so much Sen. Dodd’s revision but the U.S. government’s philosophical stance toward banking. The government wants to weed-out bank and financial institution practices that create incentives for risky/reckless practices that brought the financial system close to a collapse a year ago.

If the above is the goal, why not create a two-tier banking system? In the first tier would be investment banks. Investment banks can pay executives what they wish, but can not obtain FDIC insurance. Investors and depositors place money in them at their own risk. Any institutions whose potential failure would create systemic risk would be broken up  and sold to other banks/companies and/or dissolved.

In the second tier would be community banks. These are small, more-traditional, conservative banking operations. They would be part of the FDIC system, and be subject to executive compensation and bonus limits. They would also pay modest interest rates on savings and checking accounts and CDs. They would also hold in inventory all mortgages and loans: selling of loans to third parties – i.e. ‘originate it, and dump the risk on someone else’ would not be permitted.

Until the United States converts to a two-tier banking system, one that makes shareholders and depositors pay the price for commercial bank recklessness, and that ceases the operation of ‘too big to fail banks,’ the markets will be held hostage by this cycle of bank recklessness, followed by bailouts, followed by talk from bank executives that ‘the next generation of bankers will not make the same mistakes as the current one,’ followed by another period of banker recklessness, and another financial crisis.

Simply, the system of ‘heads the bankers win, tails the taxpayers pay’ has to end or we’ll get more of the same, 10 years down the road if not sooner.

Under the two-tier banking system, commercial banks, of course, would be free to act recklessly: it’s just that they will have to do it on investors’ or depositors’ dimes, not the U.S. taxpayers'. And they won’t be able to grow to a size that threatens the financial system.