Finally, then, let’s sketch out how things might look were all these considerations taken into account.
Commercial banks, indeed all deposit taking institutions, should be precluded by law from principal risk-taking, other than, of course, the business of lending. Principally because of their unique (and unavoidable) position under the wing of government protection, but also because of the inevitable conflicts-of-interest with their customers.
They should, in addition, be subject to strict leverage limits. This is a controversial and necessarily somewhat arbitrary matter, but in my view a bank’s total assets ought never to exceed ten times its capital. Truth is, I think even this is far too much but I doubt a lower figure would ever be accepted. The capital should be real, no fancy hybrids or other concoctions intended ultimately to game the system. If they want to issue those in addition, that’s just fine.
Next, while achieving it could be tricky, legislating (and regulating) to bring the duration of borrowing and lending into closer alignment would be a very good thing. The simplest approach is tight restrictions what can be done with call deposits, and indeed any other short-term deposits. An alternative would be a sliding scale of additional capital requirements depending on the degree of average duration mismatch. As noted earlier, reducing this mismatch would not only reduce systemic fragility but also slow the non-savings based credit creation process.
Nor should depository institutions be allowed to finance capital markets activities. Not only would such lending indirectly bring principal risk taking exposures back under the government security umbrella, it would also perpetuate the complex interrelationships that effectively forced the bailout of large universal banks. Capital markets players (whether hedge funds, broker-dealers, private equity or investment banks) are perfectly capable of seeking finance directly from the market, not as deposits or quasi-deposits, but through issuing bonds or of course equity. At least then any lenders will know they’re operating without a safety net, and that they’re making an investment decision rather than a deposit.
If, in spite of all these precautions, a bank faces a liquidity crisis (or, heaven forbid) a solvency crisis, lenders (other than depositors up to a pre-determined limit) would be subject to haircuts or equity conversions before taxpayer funds are first used.
Taken together, these restrictions and requirements would go a long way towards reducing systemic fragility as well as bringing the business of lending much closer to the ideal of intelligently recycling savings.
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As for the rest of the financial system, that’s a very large and for the most part separate issue. It’s certainly not one I want to try to tackle in any depth here. A few general comments will do, all very much in the “for what it’s worth” mold.
In principle, a dividing line between retail financial matters and the rest would be useful. Recent years have provided solid evidence that private individuals, relatively unschooled in the intricacies of finance, can easily be led astray from their own best interests. In more predatory environments, such as the USA, this tendency was at times taken to extremes, not least in the wilder regions of sub-prime mortgage lending.
The intent should be to provide simple, reliable, well thought out solutions to the more common private financial needs. Plain vanilla products if you like, each checked out and monitored by an appropriate regulatory agency. This could be supplemented by a requirement that all financial products and services offered to retail customers be as clear as possible in their terms and conditions. Straightforward language, all costs and penalties clearly enumerated upfront, and so on.
More complex products, and more risky ones, need not be banned. After all, there will be retail customers who would like to dabble in more esoteric areas. Providing they’re shown and formally acknowledge the risks, it should from that point on be a matter between consenting adults.
As should pretty much all financial relationships between professional investors. Other than having to pass a hurdle to qualify as “professional”, dealings should be subject only to standard civil and commercial laws. The authorities might require timely reporting where they feel systemic risk could raise its head, but for the rest, “caveat emptor” seems to me a reasonable rule of thumb.
Finally, and most importantly, it should be made perfectly clear that as far as all these activities and institutions are concerned, there will be no bailouts. If someone wants perfect safety, they must scuttle back to a depository institution.
Money, Credit & Financial Systems 