Do You Still Remember the Financial Crisis?

To bank or not to bank?

Do you remember the 2007-2008 financial crisis? Its daunting impact on the world economy is finally fading away and the US Federal Reserve Board is slowly moving to a less expansionary monetary policy, but the debate on its causes and, more important, on what is needed to prevent similar episodes from happening again is still very much alive.

Former US Treasury Secretary Timothy Geithner’s new book, Stress Test: Reflections on Financial Crises, has just been published, and former Federal Reserve chief Ben Bernanke has announced his book for 2015.

At the peak of the crisis, the Treasury and the Fed had to bail out financial institutions, such as insurer AIG, to prevent the crisis from spreading through a banking run–which back then had mostly affected so-called shadow banks, the financial institutions and deals not subject to the same regulations as the formal banking system.

A growing number of economists are suggesting to impose a reserve of 100% on banks deposits, stopping once and forever the risk of bank runs. The idea may appear radical and unusual, but it is supported by economists of different persuasions, such as  John Cochrane of the University of Chicago and Martin Wolf of the Financial Times, and it has been discussed by Paul Krugman in his blog for the New York Times. In fact, it is not even completely new. As explained by  Atif Mian and Amir Sufi in their book, House of Debt, a similar proposal, tagged the Chicago Plan, was circulated in 1939.  

If they had to keep whole deposits in the form of a reserve, banks as we know them would not exist anymore. They would become large equity-based institutions where the public would mainly deposit banknotes for security purposes. Deposits would stop paying interest unless held with the central bank, and commercial banks would no longer make short-term loans. The benefits of the proposal are clear: There would be a dramatic reduction in systemic risk, and the economy as a whole would stop bearing the risk of bank runs. But what are the costs?

One potential problem is that consumers would find it more costly to manage their liquidity needs. This could be partially alleviated by financial innovation. As Cochrane suggests in his paper, consumers could keep short-term deposits in money funds bearing yields with the possibility to sell small tranches every time they needed cash. ATMs would be replaced by order-to-sell minimal tranches of funds.

A much larger problem for the economy, however, would be loans, especially for small businesses. Investment banks and private equity firms could hold the fort for large corporations or offer mortgages, but what is less clear is who would provide loans for small and medium-size businesses or for private individuals. Kermit Schoenholtz, Citigroup’s global chief economist from 1997 until 2005 and now a professor at New York University’s Stern School of Business, pointed out in his blog that other financial entities could replace banks for this function. As he explains, at this point it would be the other financial institutions that would risk bank runs instead of commercial banks (with the additional problem of not having access to the lender of last resort or to deposit insurance).

It could be argued that peer-to-peer lending companies, such as Prosper or Lending Club, which act as intermediaries for small and medium-size loans, could end up replacing banks’ loans. In their case, individuals are offering the needed funds, and there is a total match of assets and liabilities. However, given their tiny sizes, at the moment this option appears as a long shot.  So maybe the time for a 100% reserve has not yet arrived.