Toward a Run-Free Financial System

John H. Cochrane
2014 Social Science Research Network  
The financial crisis was a systemic run. Hence, the central regulatory response should be to eliminate run-prone securities from the financial system. By contrast, current regulation guarantees run-prone bank liabilities and instead tries to regulate bank assets and their values. I survey how a much simpler, rule-based, liability regulation could eliminate runs and crises, while allowing inevitable booms and busts. I show how modern communications, computation, and financial technology
more » ... traditional arguments against narrow banking. I survey just how hopeless our current regulatory structure has become. runnable debt can exist as well. For funds, or in the absence of substantial equity, that means shares whose values float and, ideally, are tradable. Banks can still mediate transactions, of course. For example, a bank-owned ATM machine can deliver cash by selling your shares in a Treasury-backed money market fund, stock index fund shares, or even the bank's own shares. A bank can originate and sell mortgages, if it does not want to finance those mortgages with equity or long-term debt. Banks can still be broker-dealers, custodians, derivative and swap counterparties and market makers, providers of a wide range of financial services, credit cards, and so forth. They simply may not fund themselves by issuing large amounts of run-prone debt. If a demand for separate bank debt really exists, the equity of 100 percent equity-financed banks can be held by a downstream institution or pass-through vehicle that issues equity and debt tranches. That vehicle can fail and be resolved in an hour, without disrupting any of the operations or claims against the bank, and the government can credibly commit not to bail it out. I argue that Pigouvian taxes 2 provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests. For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax. Pigouvian taxes are more efficient than quantitative limits in addressing air pollution externalities, and that lesson applies to financial pollution. By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important. Issuers will economize on them endogenously rather than play endless cat-and-mouse games with regulators. Technology The essence of this vision is not novel. Proposals for narrow banking or equity-based banking have been with us about as long as runs and crashes have been with us. The "Chicago Plan," discarded in the 1930s, is only one of many such milestones 3 Here a second theme emerges: Modern financial, computational, and communication technology allows us to overcome the long-standing objections to narrow banking. Most deeply, "liquidity" no longer requires that people hold a large inventory of fixed-value, pay-on-demand, and hence run-prone securities. With today's technology, you could buy a cup of 2 Pigouvian taxes are designed to discourage undesirable activities, especially externalities such as pollution. Kocherlakota (
doi:10.2139/ssrn.2425883 fatcat:mobyszwtdfcgnlas4opyiagkxy