FinReg Optimal Financial System Design: Mankiw vs. Bagehot

David Wessel reports that Greg Mankiw has declared himself in favor of narrow banking:

MHow Much Leverage Do Banks Need to Be Useful?: The conversation between Alan Greenspan and some of then nation’s most prominent economists at  the Brookings Panel on Economic Activity on Friday was deemed “not for attribution” by the organizers. But Greg Mankiw, the Harvard economist, has posted his response to Greenspan on his web site. You can read it here. He largely agrees with Greenspan, but differs on one key point:

The issue concerns the importance of leverage to the viability of a financial intermediary.... Alan proposes raising capital requirements and reducing leverage, but he suggests that there are limits to how much we can do so. If we reduce leverage too much, he argues, financial intermediaries will be not be sufficiently profitable to remain viable. He offers some back-of-the-envelope calculations that purport to show how much leverage the financial system needs to stay afloat. 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.

Daniel Davies reminds us that Walter Bagehot wrote what is still nearly the last word on small banking proposals 137 years ago:

I know it will be said that in this work I have pointed out a deep malady, and only suggested a superficial remedy. I have tediously insisted that the natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it. I have shown that our system is that of a single bank keeping the whole reserve under no effectual penalty of failure. And yet I propose to retain that system, and only attempt to mend and palliate it. I can only reply that I propose to retain this system because I am quite sure that it is of no manner of use proposing to alter it. A system of credit which has slowly grown up as years went on, which has suited itself to the course of business, which has forced itself on the habits of men, will not be altered because theorists disapprove of it, or because books are written against it. You might as well, or better, try to alter the English monarchy and substitute a republic, as to alter the present constitution of the English money market, founded on the Bank of England, and substitute for it a system in which each bank shall keep its own reserve. There is no force to be found adequate to so vast a reconstruction, and so vast a destructions and therefore it is useless proposing them.

IMHO, the answers to Greg Mankiw's explicit and implicit questions appear to be:

• All successful banking systems involve maturity transformation--that enormous value is created for savers by offering them short-term and safe claims wo what are in reality long-term and risky investments.
• Throwing away the maturity transformation thus involves throwing away something of very great value to savers.
• And for what gain? The maturity transformation runs into trouble--banks cannot deliver--only when there is an enormous flight to quality--a huge spike in demand for short-term safe assets.
• Individual private banks, no matter how large, are then highly unlikely to be able to deal with such a spike in demand--after all, they can't print money.
• The government, however, can print money.

The major complaint Bagehot would have over the past two years is that the U.S. government has lent but it has not lent at a penalty rate--that it should have, as a price for its aid, have taken such large equity stakes in America's banks to make its interventions big and obvious money-makers for the Treasury, and the necessity of private banks' resorting to borrowing from the lender of last resort big and obvious money-losers for bank executives and shareholders.