A number of people have proposed that one solution to the problem of financial instability is narrow banking. While the less extreme version of narrow banking (John Kay) appears to be an application of the Volcker Rule (which I think makes sense), a more extreme version (Greg Mankiw via DeLong) proposes that banks should no longer be leveraged institutions.
What I think proponents of the latter view are missing is that the modern business cycle to which we have become accustomed relies fundamentally on flexibility in the money supply — after a recession has eliminated the excesses of the previous boom and the vast majority of the firms that remain are reasonably run and have sound business plans, lending money to support economic growth becomes a win-win solution for everybody. These businesses need to be able to borrow and everybody’s welfare is improved by allowing them to borrow without any form of rule-bound constraints.
While it is theoretically possible for commercial paper and bond markets to meet the borrowing needs of small and medium sized enterprises (SMEs), to date the problem of creating means for SMEs to access market based lending has yet to be effectively addressed. So we are left — as our ancestors were before us — with relying on banks to make appropriate decisions about lending to SMEs — and to support robust recoveries from recessions. If we take away from banks their ability to “create money” by drawing up a loan and issuing funds in form of deposits to the borrower, we take away from them their capacity to lend according to the economic demands of the business cycle, we take away the flexibility of the money supply that is natural to a banking system with fractional reserves — and, I suspect, we do grave damage to the infrastructure that drives the economic growth that pulls us out of recessions.