Will there be another huge financial crisis? As Hamlet said of the fall of a sparrow: “If it be now, ’tis not to come. If it be not to come, it will be now. If it be not now, yet it will come – the readiness is all.” So it is with banks. They are designed to fall. So fall they surely will.

A recent book explores not only this reality but also a radical and original solution. What makes attention to this suggestion even more justified is that its author was at the heart of the monetary establishment before and during the crisis. He is Lord Mervyn King, former governor of the Bank of England. His book is called The End of Alchemy.

The title is appropriate: alchemy lies at the heart of the financial system; moreover, banking was, like alchemy, a medieval idea, but one we have not as yet discarded. We must, argues Lord King, now do so.

As Lord King remarks, the alchemy is “the belief that money kept in banks can be taken out whenever depositors ask for it”. This is a confidence trick in two senses: it works if, and only if, confidence is strong; and it is fraudulent. Financial institutions make promises that, in likely states of the world, they cannot keep. In good times, this is a lucrative business. In bad times, the authorities have to come to the rescue. It is little wonder, then, that financial institutions have become so large and pay so well.

Risky assets

Consider any large bank. It will have a wide range of long-term and risky assets on its books, mortgages and corporate loans prominent among them. It will finance these with deposits (supposedly redeemable on demand), short-term loans and longer-term loans. Perhaps 5 per cent will be financed by equity.

What happens if lenders decide banks might not be solvent? If they are depositors or short-term lenders, they can demand their money back immediately. Without aid from the central bank, the only institution able to create money without limit, banks will fail to meet that demand.

Since a generalised collapse would be economically devastating, needed support is forthcoming. Over time, this reality has created a “Red Queen’s race”: governments try to make finance safer and finance exploits the support to make itself riskier.

Broadly speaking, two radical solutions are on offer. One is to force banks to fund themselves with far more equity. The other is to make banks match liquid liabilities with liquid and safe assets.

The 100 per cent reserve requirements of the “Chicago plan”, proposed during the Great Depression, is such a scheme. If liquid, safe liabilities finance liquid, safe assets – and risk-bearing, illiquid liabilities finance illiquid, unsafe assets – alchemy disappears. Finance would be safe. Unfortunately, the end of alchemy would also end much risk-taking in the system.

Lord King offers a novel alternative. Central banks would still act as lenders of last resort. But they would no longer be forced to lend against virtually any asset, since that very possibility must create moral hazard. Instead, they would agree the terms on which they would lend against assets in a crisis, including relevant haircuts, in advance.

The size of these haircuts would be a “tax on alchemy”. They would be set at tough levels and could not be altered in a crisis. The central bank would have become a “pawnbroker for all seasons”.

The value of liquid assets would then be known. They would consist of reserves at the central bank plus the agreed collateral value of any other assets. In the long run, argues Lord King, liquid assets, so defined, should match an institution’s liquid liabilities, defined as loans of a year’s maturity or less.

Several advantages

This scheme has several advantages.

First, it recognises that only the central bank can create needed liquidity in a crisis.

Second, it offers a path to a world without alchemy.

Third, it offers an option between the status quo and the extreme of 100 per cent reserve banking.

Fourth, it eliminates moral hazard, since the penalty on obtaining liquidity would be defined in advance.

Fifth, it exploits today’s circumstances, including the reserves created by quantitative easing and the infrastructure created by central banks to assess and manage collateral.

Sixth, regulation could then be reduced to just two rules: a higher maximum leverage ratio (of at most 10 to one) and the rule that the pledgeable value of assets at the central bank must exceed the value of liquid liabilities.

In spring 2015, the value of the collateral of UK banks at the Bank of England was £314 billion and of bank reserves was £317 billion. This makes total liquid assets of £631 billion. That is to be compared with deposits of £1.82 trillion.

Over time, this gulf could be eliminated. The Bank of England should make existing reserves permanent. It could raise reserves by further permanent increases in the monetary base. Finally, it could agree the pledgeable value of more assets.

Radical proposals

This is a radical and interesting set of proposals. If the proposed rule were in effect, the only people with an interest in “running” from a bank would be long-term lenders and shareholders.

But if share prices did crash and long-term loans dried up, management would be under the right sort of pressure. It would also give time to resolve the financial position of institutions in difficulty. If equity were insufficient, then these losses would fall on longer-term creditors in a predefined order.

This scheme has drawbacks. Pledgeable values would have to vary with economic conditions, which could create a degree of stress. But it is a valiant attempt to discipline a financial system that makes promises it cannot keep.

At the very least, the cost of making those promises would be made predictable and transparent. Alchemy would be less lucrative; banks would be better capitalised; and runs by short-term creditors should cease. These ideas deserve open-minded consideration.

– Copyright The Financial Times Limited 2016