In the end, clarity about the regulatory perimeter is both desirable and unavoidable – a task given to the Financial Policy Committee as part of the Bank of England’s new responsibilities. And the attraction of the more radical solutions is that they offer the hope of avoiding the seemingly inevitable drift to ever more complex and costly regulation. The broad answer to the problem is likely to be remarkably simple. Banks should be financed much more heavily by equity rather than short-term debt. Much, much more equity; much, much less short-term debt. Risky investments cannot be financed in any other way. What we cannot countenance is a continuation of the system in which bank executives trade and take risks on their own account, and yet those who finance them are protected from loss by the implicit taxpayer guarantees. The difficulty is in finding the right practical way to achieve that. Some of the solutions that economists have proposed have been dismissed by some as impractical and pie in the sky. But I am reminded of Keynes’ dictum that “practical men who believe themselves to be quite exempt from any intellectual influence are usually the slaves of some defunct economist” (Keynes, 1936). Of all the many ways of organising banking, the worst is the one we have today. I have suggested a number of ways in which the system could be reformed. But making the right choice will take much careful thought and a good deal of time.
This leads to the limiting case of proposals such as Professor Kotlikoff’s idea to introduce what he calls “limited purpose banking” (Kotlikoff, 2010). That would ensure that each pool of investments made by a bank is turned into a mutual fund with no maturity mismatch. There is no possibility of alchemy. It is an idea worthy of further study. Another avenue of reform is some form of functional separation. The Volcker Rule is one example. Another, more fundamental, example would be to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking (for example, as proposed by Fisher, 1936, Friedman, 1960, Tobin, 1987 and more recently by Kay, 2009). In essence these proposals recognise that if banks undertake risky activities then it is highly dangerous to allow such “gambling” to take place on the same balance sheet as is used to support the payments system, and other crucial parts of the financial infrastructure. And eliminating fractional reserve banking explicitly recognises that the pretence that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe  8  BIS Review 140/2010  deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets. The advantage of these types of more fundamental proposals is that no tax or capital requirement needs to be calibrated. And if successfully enforced then they certainly would be robust measures.