Safe Banking

Just in time for the new year, I've got a new article called Safe Banking up on SSRN. The article is a first principles reexamination of the industrial organization of financial services. It identifies the institutional combination of deposits and lending as the key problem in our financial system. We've developed an enormous financial regulatory state to attempt to hold these lending and deposits together, but it might be time to admit that bank regulation just doesn't work and can't. Our bank regulatory system is simply too complex and too politicized to work flawlessly as it must.

My solution is a radical, yet conservative structural change that has become possible because of recent technological and market changes: mandate the institutional separation of deposits from lending in both traditional and shadow banking markets, a reform I call "Pure Reserve Banking". Pure Reserve Banking means 100% reserve banking plus withdrawal of the entire panoply of government support and subsidization of shadow banking products. There's a host of financial stability and political economy benefits that would flow from such a change, but at core Pure Reserve Banking means ending the subsidization of a volatile growth economy in which gains are privatized and losses socialized and shifting to a more stable—and inherently equitable—growth economy.

The abstract is below the break:

Banking is based on two fundamentally irreconcilable functions: safekeeping of deposits and relending of deposits. Safekeeping is meant to be a risk-free function, but using deposits to fund loans inevitably poses risk to deposits, thereby undermining the safekeeping function. The expensive, inefficient, and unreliable apparatus of bank regulation is an attempt to square the circle between safekeeping and lending: government liquidity and deposit insurance facilities, capital and reserve requirements, investment restrictions, and supervisory examinations are all aimed at keeping the risks of the lending function in check so as to ensure the safety of deposits.

This Article argues for splitting the lending function from the safekeeping function in both traditional and shadow banking markets through what it terms “Pure Reserve Banking.” In a Pure Reserve Banking regime, “safe banks” would offer safekeeping and payment services, and nothing else. Loans would be a function solely of capital markets, which would operate without government facilitation of shadow banking deposit substitutes. Historically, a separation between deposits and lending was not possible, but it is with today’s deep and efficient capital markets, which already provide the funding for much of the borrowing in the economy.

Splitting the lending function from the safekeeping function would protect the money supply from the market, and the market from the money supply. It would enable the government to end its massive support of both formal banking markets and shadow banking markets and thereby remove the moral hazard that encourages asset bubbles through overlending. At the same time, divorcing lending from safekeeping would instill greater market discipline on lending markets because lending institutions could be allowed to fail without endangering the money supply. Delinking deposits and lending would eliminate the root cause of financial market instability and enable truly safe banking that is not dependent upon an increasingly complex, politicized, and untenable regulatory system.

Comments

[Warren]

Thank you for a very thoughtful article (the full version on SSRN) which makes quite a strong case for separating the lending and depository functions. The basic function of Maturity Transformation of funds is where the risk is, as well as the key tool to efficiently allocate growth capital in a modern economy. This is true regardless of whether the depository and lending functions are in the same firm or in different firms. My own observation is that the banking industry is generally far better at forecasting and managing the duration of its assets (loans) than it is at managing the maturity of the liabilities (deposits/borrowings). This makes the basic task of transformation far more difficult and risky. So then we bring in deposit insurance and liquidity coverage ratios, legions of examiners and stress-tests, etc. Perhaps the core presumption that the state can realistically guarantee risk-free deposit funds for all, up to the current limits, is the flaw in the system that causes the problems and failures of market discipline (including all the various ways you described where that public guarantee gets subverted into "subsidies" of the shadow banking transactions). The article is quite humble about the likelihood of adoption of Pure Reserve Banking in the near term and I agree, but it may be possible to make some progress by scaling back the overgrown expectation of risk-free deposits. That in itself can be considered a rather regressive subsidy, as most depositors tend to have much less than $250K on deposit. Hopefully this article will prompt more exploration and research into the foundational structure of FIs, if only for the opportunities to reduce the enormous deadweight loss of the current and growing regulatory framework.