Paul Romer suggests that public funds should be used as equity of new “good” banks. With standard leverage ratios, such banks could go a long way to solving the “credit crunch.” And it looks like a good proposal because it appears to be a good use of public funds. But are there possible pitfalls?
A possible problem with the Romer proposal is one relating to bank runs. The new good banks would be well known. What if depositors “run” from the big existing banks to the new banks? The bank regulators will then have an even bigger problem in their hands: How to contains such bank runs.
In a strange sense, if all big banks were equally at risk, this limits the incentive for bank runs, and yet such a “risky” scenario seems the best. The old Bagehot rule has always been that there should be a bank of last resort, but there should be uncertainty as to how and when it will act to save a “bad” bank. This seems to be the practical rule to limit moral hazard in the modern banking system.