In a previous post, I explained that banks are inherently fragile. One way to make them more robust is to increase equity capital requirements. This is the remedy advocated by Bloomberg View's editors. The banks call it radical but it's really pretty moderate, because it leaves the basic structure of banking alone. The same is true of calls to make the banks smaller. Smaller banks are still banks. 

A genuinely radical approach would be to kill banking as we know it. Rip all banks, large or small, in two -- separate deposit-taking from credit-creation. Back the deposits one-for-one with reserves at the central bank. Then fund loans not with deposits or other money-like liabilities but by tapping investors who understand they've put their savings at risk.

This approach, unfamiliar as it sounds, has a long and distinguished academic lineage. Luminaries such as Irving Fisher, Milton Friedman and James Tobin have all advocated it.

For instance, the "Chicago Plan" was developed in the 1930s by Fisher and Henry Simons. Friedman later endorsed it as well. Two researchers at the International Monetary Fund have written an up-to-date appraisal -- and the proposal, in theory, does everything its designers claimed 80 years ago. The first 20 pages of this paper are an excellent primer.

Tobin explained the essence of the idea in 1987 at the Federal Reserve's annual economic symposium in Jackson Hole:

"To diminish the reliance of the payments system on deposit insurance, I have proposed making available to the public what I call 'deposited currency.' Currency -- today virtually exclusively Federal Reserve notes -- and coin are the basic money and legal tender of the United States. They are generally acceptable in transactions without question. But they have obvious inconveniences -- insecurity against loss or theft, indivisibilities of denomination -- that limit their use except in small transactions (or in illegal or tax-evading transactions.) These disadvantages, along with zero nominal interest, lead to the substitution of bank deposits for currency. But deposits suffer from their own insecurity, unless guaranteed by the government; and the guarantees of deposit insurance are subject to the abuses discussed above.
"I think the government should make available to the public a medium with the convenience of deposits and the safety of currency, essentially currency on deposit, transferable in any amount by check or other order…The Federal Reserve banks themselves could offer such deposits, a species of 'Federal Funds.'"

More recently, Boston University economist Larry Kotlikoff has argued that we need to completely separate money from credit by introducing what he calls "limited purpose banking." It's basically the same idea.

In this new world, banks would essentially be payments companies competing to offer the most convenient services without putting anyone's savings at risk. How would they make money? By paying a lower interest rate than they receive from their reserves at the central bank, or by charging fees, or both. There would be no need for deposit insurance and regulation of this very simple business would be straightforward.

What about the lending side of today's banking industry? There would be lending companies instead -- funded exclusively by equity investors, who consciously choose to put their savings at risk rather than hold them as deposits or other money-like bank liabilities. These new credit vehicles could take a variety of forms. Some might resemble bond mutual funds. Others could operate more like venture capital funds, complete with long lockup periods.

From the perspective of many borrowers, things might not look that different. Large corporations already borrow mainly by issuing bonds, so the change for them would be relatively inconsequential. Smaller firms and retail borrowers could obtain financing from institutions that look like local banks. Instead of relying on deposits, however, these outlets would actually be subsidiaries of lending companies funded by equity investors.

The emergence of new types of lenders highlights one possible hazard of this reform: their liabilities might morph into new kinds of near-money. If that happened, the new lenders would have become banks, thus susceptible to runs, thus requiring government support for their risky lending -- and we'd be back where we started. The IMF paper emphasizes that the government would face a constant, but not insurmountable, challenge in preventing the re-emergence of "shadow banks."

Would there be enough lending to support a desirable rate of investment under these new rules? There would likely be less lending than now, because the implicit public subsidy to banks' operations would have gone. But from a resource-allocation point of view, that's a good thing not a bad thing. A subsidy that promotes risky lending isn't worth preserving.

Abolishing banking isn't a small step, and I'll discuss some objections in a subsequent post. But the strangeness of the idea shouldn't rule it out, because as Tobin said (see my earlier post) the current marriage between deposit-taking and credit creation was itself a historical accident -- and it's a union that hasn't worked out so well. Radical-seeming alternatives should be part of the conversation.

(Matthew C. Klein is a contributor to the Ticker. Follow him on Twitter.)