California Public Banks concept demonstrates solid lateral thinking

AB-857 is a bill in the California state assembly that would allow cities to use state banking laws to set up public banks. What little that has been written on the subject tends to stress that the new banks will right many wrongs, will not be expensive boondoggles and will help California wean itself from dependence on Wall Street.

It will take an economic cycle to determine whether these new institutions really can right many wrongs while not becoming a financial burden on the municipalities which sponsor them. What is interesting today is the fact that this bill was even put forward in the first place. It shows some very progressive (traditional meaning) thinking going on in Sacramento.

Grumbling about the extractive ways of Wall Street has a pedigree stretching back almost to the first gathering under the Buttonwood Tree. Wall Street became the focus of financial activity in the US due to the same clustering effect which built many other industries during and after the industrial revolution. “Silicon Valley” and its many imitators are recent manifestations of our tribal, clustering instincts. So, nothing new to see here.

What is new is the willingness of cities in California to consider alternative ways of financing activity in their local economies. That willingness and, one has to assume, confidence that the cities can pick up enough slack in their local economies to make a public bank work appears to stem from two changes in the financial landscape. They are disappointment with the incumbent banks and the introduction of slick new tools.

The leading municipalities are no longer convinced that the “too big to fail banks”, stitched together in the wake of the 2008 Financial Crisis, have their interests at heart. In the main this feeling of disappointment has been fueled by the consolidation and efficiency drives at the remaining institutions. Local banks seem too few and minnows compared to the big money center banks. For California, the Wells Fargo scandal related to opening extra accounts without the knowledge of clients was the straw that broke the camel’s back. Other western states have complained that certain banks have large imbalances between deposits and loans when considered on a statewide basis. When these feelings, perceptions and, in some cases, cold hard facts are put together, perhaps it is not surprising that frustration and disappointment have paved the path for AB-857.

The change which very few people are talking about is the new tools that are available to almost anybody nowadays. In the previous century, banks had large competitive moats driven by access to capital and technology. But, thanks to innovative companies providing everything from credit card processing to loan origination and consolidation to low/no cost access to capital markets, it is possible using SaaS (Software as a Service) to build a modern financial institution largely in software. Identity has advanced in leaps and bounds. Social graphs have been harnessed to give a better view of bankablility than simple credit scores alone. Digitally native markets have sprung up to provide both liquidity and derivatives to manage risk profiles. And, deploying a fleet of branded ATM machines seems like such an outdated concept in this era of tap and pay cards and cellphone apps.

One could literally piece together all the moving parts a public bank would need from existing toolkits with a small team of qualified software engineers. Add on some adult supervision to control for financial and regulatory risks and the idea of launching a special purpose public bank is no longer such a wild idea.

The next consideration is how will it work and the risks that lurk underneath the bright shiny surface of the public banking concept.

Despite all the disappointment with money center (aka “Wall Street”) banks and the availability of tools to allow for DIY bank building, one thing that will not change is the nature of banking itself.

At the simplest level banks take in short term liabilities (customer deposits, for example) and create long term assets (loans). In general, the cost of short term liabilities (interest paid to depositors) is lower than the income derived from long term assets (interest received from borrowers). This is commonly referred to as “Maturity Transformation” and lies at the heart of any bank’s role in any economic system.

When things are chugging along in relative equilibrium, the bank makes a gross profit on the difference and can use that excess to build up reserves and capital, which can be reinvested to grow the bank or to pay out shareholders (in this case, the city). Either way, in an AB-857 world, the profits are reinvested in the local economy rather than being captured in an East Coast bank holding company. So, as long as a bank can maintain confidence amongst the suppliers of short term capital (depositors, wholesale finance and others) that the long term assets are of sound quality (both default wise and earnings wise), the public bank should be a net positive for the local economy it is designed to serve. It will increase the velocity of money locally and ensure that any fee drag is largely recaptured in the local economy rather than paid away to institutions outside the local economy.

The only fly in the ointment that voters should be worried about is the nature of fractional reserve banking. This fundamental banking concept allows for leveraging the deposit base and traditionally has not worked well with high geographic concentration of assets and liabilities. By definition and likely mission statement, the public banks will seek to concentrate activities within city limits as much as possible. It is not only possible but somewhat likely that public banks are susceptible to creating assets (loans) that are underpriced (relative to risk) to achieve political goals. That means municipal public banks open themselves to bank runs as depositors, from time to time, worry about the overall quality of the loan book. Although small depositors will be made whole through FDIC or FSLIC deposit insurance schemes (depending on how they structure themselves), the financial pain of any panic will fall on the city. Since banks by their nature tend to be leveraged, any loss of confidence could be magnified at the worst possible time because crises rarely happen in a vacuum.

The conclusion we should draw so far it that there is something interesting and quite exciting happening in Sacramento and the big cities of California. AB-857 implies solid lateral thinking and a healthy consideration of how to leverage the financial muscle of Californians to build new and efficient financial networks that will generate positive local feedback loops. The disappointment with money center banks and the availability of cutting edge off-the-shelf tools are both real and critical to the story. But, before we declare this initiative an unalloyed win for Californians everywhere, it is important to recognize that cities are venturing into a market niche for which they may not be fully prepared, especially when the chips are down and depositors rush the exits. Given the massive premiums that non-bank players charge (looking at you, pay-day lenders), there is room for banks to deliver financial services to the underbanked at a profit. But, it may take a few crises before these new public banks can actually calibrate their pricing so that it creates the capital cushion they will need to survive the tough times while still delivering on the promise of better banking for all its citizens.

Tradition finance guy looking to use new tools to remake the financial landscape

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