Yesterday, I addressed the concern that the financial reform legislation floating around Congress doesn't do enough to create higher capital requirements for banks. I explained that it does require new limits be set, but that specific rules are more appropriate for regulators to address in a global discussion. We will likely see more tangible rules for higher capital requirements over the next few years, once global regulators sort out reasonable changes. But what if banks' capital requirements were much, much higher -- what if they were required to hold 100% reserves against demand deposits?

Andrew Ross Sorkin makes a similar argument to mine from yesterday about capital requirements in his New York Times column today. Of course, I didn't have the pleasure of discussing capital requirements over cookies with Treasury Secretary Timothy Geithner like he did. Towards the end of the article, he brings up the 100% reserves against demand deposits idea, only to quickly dismiss it without any analysis.

Harvard economist Greg Mankiw suggested the idea picked up by Sorkin. For those unfamiliar with the term, demand deposits are very liquid depository accounts. Think most checking and savings accounts. Here's the blog post by Mankiw Sorkin refers to:

Indeed, I think it is possible to imagine a bank with almost no leverage at all. Suppose we were to require banks to hold 100 percent reserves against demand deposits. And suppose that all bank loans had to be financed 100 percent with bank capital. A bank would, in essence, be a marriage of a super-safe money market mutual fund with an unlevered finance company. (This system is, I believe, similar to what is sometimes called "narrow banking.") It seems to me that a banking system operating under such strict regulations could well perform the crucial economic function of financial intermediation. No leverage would be required.

One thing such a system would do is forgo the "maturity transformation" function of the current financial system. That is, many banks and other intermediaries now borrow short and lend long. The issue I am wrestling with is whether this maturity transformation is a crucial feature of a successful financial system. The resulting maturity mismatch seems to be a central element of banking panics and financial crises. The open question in my mind is what value it has and whether the benefits of our current highly leveraged financial system exceed the all-too-obvious costs.

This isn't as crazy an idea as it seems. As Mankiw mentions in the second paragraph, banks have developed a dangerous habit of lending money in the long term, but borrowing to fund that lending in the short-term. That can cause banks to fail in a credit crunch if they can't turn over their debt. I can't think of any reason why this "maturity transformation" is necessary. (But if you can, comment away!)

Now, it may appear that if banks were required to retain so much capital, they might have more trouble lending. That's probably true -- credit wouldn't flow as freely. But remember: they would only retain 100% of capital on demand deposits, not other types of accounts. And if there's a sufficiently strong demand for lending beyond that, then what borrowers are willing to pay should match up with what the capital markets are willing to invest. And that's where securitization should come in. Any loans fully securitized, and consequently owned by investors, would not require additional capital to be held by banks. They would be fully funded by the capital markets.

Of course, this is all probably an exercise in theory. Most bank executives would have a heart attack if you told them they needed to retain 100% of their demand deposits. It would certainly curb their profits, but if securitization picked up the slack, it wouldn't necessarily wipe out their lending. Indeed, this proposal could even rein in lending appropriately, as credit was far too easy over the past decade or so leading up to the crisis. Such a transformation would take quite a few years, however, as it would be an extraordinary adjustment for banks.

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