Banking is based on two fundamentally irreconcilable functions: safekeeping of deposits and relending of deposits. Safekeeping is meant to be a risk-free function, but using deposits to fund loans inevitably poses risk to deposits, thereby undermining the safekeeping function. The expensive, inefficient, and unreliable apparatus of bank regulation is an attempt to square the circle between safekeeping and lending: government liquidity and deposit insurance facilities, capital and reserve requirements, investment restrictions, and supervisory examinations are all aimed at keeping the risks of the lending function in check so as to ensure the safety of deposits.
This Article argues for splitting the lending function from the safekeeping function in both traditional- and shadow-banking markets through what it terms “Pure Reserve Banking.” In a Pure Reserve Banking regime, “safe banks” would offer safekeeping and payment services, and nothing else. Loans would be a function solely of capital markets, which would operate without government facilitation of shadow-banking deposit substitutes. Historically, a separation between deposits and lending was not possible, but it is now feasible with today’s deep and efficient capital markets, which already provide the funding for much of the borrowing in the economy.
Splitting the lending function from the safekeeping function would protect both the money supply from the market and the market from the money supply. It would enable the government to end its massive support of both formal-banking markets and shadow-banking markets and would thereby remove the moral hazard that encourages asset bubbles through overlending. At the same time, divorcing lending from safekeeping would instill greater market discipline on lending markets because lending institutions could be allowed to fail without endangering the money supply. Decoupling deposits and lending would eliminate the root cause of financial market instability and enable truly safe banking that is not dependent on an increasingly complex, politicized, and untenable regulatory system.