Optimal Investment and Business Cycles Under Alternative Banking Systems

Abstract

The financial and economic crisis of 2007-2011 in the U.S. and Europe raises a number of fundamental questions on the role of banks in the financial system. The response so far has resulted in a reregulation of banks and certain systematically important non-bank financial institutions. One pillar of this new banking regulation is to adopt something that has come to be called the Volcker Rule. This rule imposes certain constraints on bank asset management and pushes banks in the direction of deposit-taking and financial intermediation within a fractional reserve system. In a world where real investment is allocated according to the CAPM we argue that that a fractional reserve banking system characterized by credit creation and lending leads to excessive real investment that in turn amplifies business cycles. Therefore we suggest the regulatory process should go even further by restricting bank asset management to holding 100 percent reserves in the form of currency and deposits at the central bank. Non-bank financial institutions should then carry out the risky lending function and trading now carried out by banks.