Sadly, I do not think that he actually means that we should eliminate fractional reserve banking — which, to many Austrian economists is nothing but legalized fraud — but that he merely uses it as a scarecrow... but nonetheless, just the fact that he mentions it as the best solution to the banking crisis is an amazingly big step forward.
In September 2007, everyone thought that the crisis was one of liquidity and as a result there was an expectation central banks could provide the solution. But it quickly became clear that it was in fact a crisis of solvency.
[…] And not only are banks’ assets risky, but banks are highly leveraged institutions. This leaves them heavily exposed – with very high debt-equity ratios, small movements in asset valuations are enough to wipe out their equity and leave banks insolvent. That means the distinction between illiquidity and solvency can be difficult in practice – the difference in timing might be just a few days. If a crisis is in fact one of insolvency, brought on by excessive leverage and risk, then central bank liquidity provision cannot provide the answer. Central banks can offer liquidity insurance only to solvent institutions or as a bridge to a more permanent solution.
It is this structure, in which risky long-term assets are funded by short-term deposits, that makes banks so hazardous. Yet many treat loans to banks as if they were riskless. In isolation, this would be akin to a belief in alchemy[…]For all the clever innovation in the financial system, its Achilles heel was, and remains, simply the extraordinary – indeed absurd – levels of leverage represented by a heavy reliance on short-term debt
Modern financiers are now invoking other dubious claims to resist reforms that might limit the public subsidies they have enjoyed in the past. No one should blame them for that – indeed, we should not expect anything else. They are responding to incentives.
Basel III on its own will not prevent another crisis for a number of reasons. First, even the new levels of capital are insufficient to prevent another crisis. Calibrating required capital by reference to the losses incurred during the recent crisis takes inadequate account of the benefits to banks of massive government intervention and the implicit guarantee.
So, if we cannot rely solely on these types of measures, are there more fundamental directions in which we could move that would align costs and benefits more effectively?
One simple solution, advocated by my colleague David Miles, would be to move to very much higher levels of capital requirements – several orders of magnitude higher.
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.
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 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.