Via Brad DeLong, I see that Greg Mankiw seems to favor narrow banking: require banks to hold all their deposits in liquid, short-term assets, thus obviating the risk of financial crises.

I’m glad to see Greg trying to think this through; but I’d argue that this is all wrong, on two levels: if it were possible, it would do away with the main purpose of banks, and anyway, it’s not possible.

Where Greg goes astray here, I think, is by trying to apply Modigliani-Miller, which says that capital structure doesn’t matter. If you look at the assumptions behind that argument, you realize that it requires that all assets be perfectly liquid. They aren’t, of course — and that’s precisely why we need banks.

I think of the whole bank regulation issue in terms of Diamond-Dybvig, which sees banks as institutions that allow individuals ready access to their money, while at the same time allowing most of that money to be invested in illiquid assets. That’s a productive activity, because it allows the economy to have its cake and eat it too, providing liquidity without foregoing long-term, illiquid investments. If you were to enforce narrow banking, you would be denying the economy one of the main ways we manage to reconcile the need to be ready for short-term contingencies with the payoff to making long-term commitments.

And anyway, how would you enforce it? Yes, you could require that depository institutions be narrow banks — but depository institutions aren’t where the problem is. The recent crisis was centered in repo — and as Gary Gorton (and others) insist, repo — overnight loans in which many businesses park their funds — are money just as much as bank deposits are. And if depository institutions were forced to be narrow banks, even more funds would migrate to shadow banks. So would you try to ban repo? Where does it stop?

That’s why regulation has to be smarter than something as simple as narrow banking. Government backing — the 21st-century version of deposit insurance — plus regulation so that the backed institutions don’t abuse the privilege is still the way to go.

Ezra Klein expresses some skepticism about my skepticism. I worried that no financial reform will work if the government is dominated by people who don’t believe in regulation; Ezra counters that the FDIC has been pretty robust to idiots in power.

Actually, we’re both right.

The New Deal system of financial regulation really had two main parts: deposit insurance and bank capital requirements. The first ruled out bank runs; the second reduced the incentive for banks to take advantage of guarantees to gamble with other peoples’ money. The capital requirements actually worked better than they really should have, because of a third factor: limited competition meant that banks had a large franchise value, which they were reluctant to endanger.

This whole system was fairly idiot-proof. Not totally: when Reagan-era legislators decided to avoid covering losses at S&Ls by deregulating their investments, hoping that they would earn their way out of the hole, the result was a disaster. But all in all the system didn’t require smart or even especially competent leadership.

But the old system faced a relatively simple task: regulating and insuring depository institutions. We knew what banks were, and we knew what undue risks looked like.

Now the problem is regulating shadow banking — non-depository banking. So right from the beginning we have the problem of deciding what is a bank, and what liabilities need deposit-type guarantees. All short-term debt? Only some kinds of repo? Who do we need to be worried about?

The solution in proposed legislation is a sort of pornography test: we’ll know it when we see it. I don’t have a better idea, but this does leave us at the mercy of future regulators who will look at future Lehmans and declare them non-systemic.

Furthermore, we probably can’t count on letting franchise values do most of the work of controlling risks. So we’re going to need some active monitoring, again without simple rules likely to be adequate. So again we’ll need some serious regulatory commitment.

Where possible, the system should be automatic — that’s why the Frank bill, which sets a maximum leverage ratio of 15, is better than the Dodd bill, which leaves all that discretionary. But I just don’t see a way to make this thing run on autopilot.

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And he has some suggestions for further reading:

FinReg Reading
Paul Krugman