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Safe Banking: Finance and Democracy Adam J Safe Banking: Finance and Democracy Adam J. Levitin† Banking is based on two fundamentally irreconcilable functions: safekeeping of deposits and relending of deposits. Safekeeping is meant to be a risk-free func- tion, but using deposits to fund loans inevitably poses risk to deposits, thereby un- dermining the safekeeping function. The expensive, inefficient, and unreliable ap- paratus of bank regulation is an attempt to square the circle between safekeeping and lending: government liquidity and deposit insurance facilities, capital and re- serve requirements, investment restrictions, and supervisory examinations are all aimed at keeping the risks of the lending function in check so as to ensure the safe- ty 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 func- tion 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 now feasible 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 both 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 would thereby remove the moral haz- ard that encourages asset bubbles through overlending. At the same time, divorc- ing lending from safekeeping would instill greater market discipline on lending markets because lending institutions could be allowed to fail without endangering the money supply. Decoupling deposits and lending would eliminate the root cause of financial market instability and enable truly safe banking that is not dependent on an increasingly complex, politicized, and untenable regulatory system. † Professor of Law, Georgetown University Law Center. This Article has benefited from presentations at the Duke Law School faculty workshop, Georgetown University Law Center faculty workshop, the University of Maryland Francis King Carey School of Law faculty workshop, the University of Pennsylvania Institute for Law and Economics’ Annual Meeting, and the University of Virginia Law and Economics Workshop; comments from Andrew Blair-Stanek, William Bratton, Maxwell Chibundu, Peter Conti-Brown, Anna Gelpern, Erik Gerding, James Grimmelmann, Edmund Kitch, James Kwak, Chrystin Ondersma, Marcelo Prates, Morgan Ricks, Steven Schwarcz, Carolyn Sissoko, Maxwell Stearns, Andrew Verstein, and Susan Webber; and the research assistance of Anna Sandor. 357 358 The University of Chicago Law Review [83:357 INTRODUCTION ..................................................................................................... 359 I. THE DUAL FUNCTIONS OF MODERN BANKING ............................................... 366 A. The Deposit Function .......................................................................... 366 B. The Lending Function ......................................................................... 367 C. How the Banker Got His Business: A Just-So Story ......................... 369 1. The Goldsmith’s Tale. .................................................................. 370 2. The Depositor’s Tale. .................................................................... 375 3. The Banker’s Tale. ........................................................................ 376 II. SQUARING THE CIRCLE? ATTEMPTS TO MAKE BANKING SAFER ..................... 379 A. Direct Government Credit: Government Banks ................................ 379 B. Government Guaranties: Deposit Insurance and Liquidity Provision .............................................................................................. 383 C. Shadow Banking: Government Facilitation of Deposit Substitutes ........................................................................................... 388 1. Repos. ........................................................................................... 391 2. Swaps. ........................................................................................... 394 3. Securitization. ............................................................................... 396 4. Agency securities. ......................................................................... 400 5. Commercial paper. ....................................................................... 402 6. Money market mutual funds. ...................................................... 403 7. Uninsured bank deposits. ............................................................ 407 D. The “Safety” of “Safe Assets” .............................................................. 407 III. SAFE BANKING .............................................................................................. 411 A. Narrow Banking .................................................................................. 411 B. 100% Reserve Banking ........................................................................ 413 1. Historical 100% reserve–banking proposals. .............................. 414 2. Pure Reserve Banking. ................................................................. 417 3. The feasibility of Pure Reserve Banking. .................................... 419 4. What would Pure Reserve Banking look like? ............................ 422 C. Effect on the Deposit Function ........................................................... 425 D. Effect on the Lending Function .......................................................... 427 1. Source of funds. ............................................................................ 427 2. Maturity transformation. ............................................................. 428 3. Money creation. ............................................................................ 431 4. Risk management and market discipline. .................................. 436 5. Bubble prevention. ....................................................................... 437 E. Effect on Regulation ............................................................................ 437 1. Elimination of deposit insurance, the Federal Reserve System, and prudential bank regulation. ................................... 438 2. Reduction of the compliance costs of bank regulation. ............... 438 3. Depoliticization of bank regulation. ............................................ 439 4. Increased transparency of monetary politics. ............................. 441 5. Elimination of the political pressure of “too big to fail.” ............ 447 2016] Safe Banking: Finance and Democracy 359 6. Challenges of innovation. ............................................................. 448 F. Effect on the Economy ......................................................................... 450 G. Effect on Regulation Internationally .................................................. 452 H. So Why Aren’t We There Yet? ............................................................. 453 CONCLUSION ........................................................................................................ 454 INTRODUCTION Modern banking holds out two promises. Banks promise safekeeping of and ready access to depositors’ funds (the “Depos- it Function”). Banks also promise to be a ready source of funding for borrowers (the “Lending Function”). This Article argues that these two promises are fundamentally inconsistent and irrecon- cilable and that the tension between them is the root cause of instability in the financial system. The institutional combination of deposit-taking and lending is known as “fractional reserve banking,” because only a fraction of deposits are retained as reserves; the rest are reloaned. Frac- tional reserve banking is an inherently unstable system. The risks involved with lending cannot be squared with an absolute promise of safekeeping and liquidity absent the expensive, inef- ficient, and unreliable apparatus of modern bank regulation: central bank liquidity facilities, deposit insurance, capital and reserve requirements, investment restrictions, and supervisory examinations. The machinery of modern bank regulation is pri- marily (if sometimes indirectly) an effort to square the circle be- tween the Deposit and Lending Functions, and it inevitably re- sults in more-elaborate and more-cumbersome regulations as well as the erosion of market discipline. Modern banking regulation, however, covers only part of the market providing Deposit and Lending Functions. The past sev- eral decades have witnessed the development of a shadow- banking system—financial markets such as the markets for money market funds, repos, credit derivatives, commercial pa- per, and securitization, which provide substitute deposit and lending products but exist outside the bank regulatory system. Shadow-banking markets exist because of a range of govern- ment interventions that encourage investors to view shadow- banking products as functional substitutes for bank deposits in terms of safety, while offering greater yield. Shadow banking is effectively subsidized by favorable regulatory treatment. The ex- istence of shadow banking enables regulatory arbitrage
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