Economic Stability Under Alternative Banking Systems

In this paper we show that in a world where productive investment is allocated according to the CAPM, a fractional reserve banking system that facilitates investing and money creation is not Pareto efficient and leads to excessive productive investment that in turn amplifies future business cycles. These results follow from a model based on CAPM, rational expectations and a linear homogenous production function. The regulatory process should consider going even further than the Volcker rule by restricting bank investments to currency in vault and deposit accounts on the central bank. Nonbank financial institutions should then carry out the risky financial intermediation function and trading now carried out by banks