Mervyn King on Radical Bank Reform

How do we put more of the costs of maturity mismatch on the shoulders of those who reap the benefits?....

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. A related proposal is to ensure there are large amounts of contingent capital in a bank's liability structure....But unless complete, capital requirements will never be able to guarantee that costs will not spill over elsewhere. This leads to the limiting case of proposals such as Professor Kotlikoff's idea to introduce what he calls "limited purpose banking". That would ensure that each pool of investments made by a bank is turned into a mutual fund with no maturity mismatch. There is no probability of alchemy. IT IS AN IDEA WORTHY OF FURTHER STUDY.

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....Eliminating fractional reserve banking explicitly recognisees that the pretence that risk-free deposits can be supported by risky assets is alchemy......

The advantage of these types of more fundamental proposals is that no tax or capital requirement needs to be calibrated......But a key challenge is to ensure that maturity transformation does not simply migrate outside of the regulated perimeter, and end up benefiting from an implicit public subsidy. That is difficult because it is the nature of the services, not the institutions, that is the concern.....

The broad answer to the problem is likely to be remarkably simple. Banks should be financed much more heavily by equity rather than short-term debt.....

Of all the many ways of organising banking, the worst is the one we have today.