Many economic crises start on Wall Street and it is often not clear whether fundamental problems caused the financial markets to crumble or whether it was the bankers that brought down the whole economy. The latest crisis made the proponents of the latter view more vocal but there are still moments in history that suggest that the mistakes of the financial markets can be easily contained; just think of the dot-com bubble. When the bubble burst in 2001, stock markets plunged but the real economy only quivered. Learning from that, regulators want to prevent any distress on the financial markets or at least limit the damage to the real economy.
Probably the most vulnerable link between the financial sector and the rest are banks. When banks suffer, the rest of the economy gets into trouble as well. Consequently, the regulators want to protect banks from any sort of trouble as they want to isolate the real economy from shocks caused by the financial markets. However, with all the capital regulation, risk-weighted assets, and so on, they focus predominantly on the asset side of banks’ balance sheets. What if there is another way?
Banks are not vulnerable because of their assets but because of their liability structure. Dependence on deposits makes them prone to runs, although they can be structurally healthy and only in need of liquidity. John Cochrane suggests a solution. What if all banks were financed only by equity? What if you did not deposit your salary in a bank, but you instead immediately bought shares of the bank? The idea sounds outrageous at first, but Cochrane argues that not much would actually change. We would be still able to withdraw money at ATMs or pay for a sandwich with a credit card. The only difference would be that we would not reduce the amount of money deposited on our account but we would sell a portion of our bank shares – just a technical change from the consumer’s perspective. And luckily, today’s technology would allow that.
When depositors actually own shares, they have no reason to run. Even if they are concerned with the bank’s actions, they would not sell out indefinitely as the bank’s assets remain safe and stable. Thus the banks are safe from runs and they, along with their shareholders, have to only endure mild swings in value of their assets. The discussion is still at the beginning and there are many potential pitfalls along the way, but thinking about our structural problem in this way can help us to rethink the status quo and stop kicking the can down the road.
Reference: Cochrane, J. H. (2014). Toward a run-free financial system. Available at SSRN 2425883. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2425883. Available here.
Link to FED symposium discussing the topic.