Henry Calvert Simons, a University of Chicago economist who wrote extensively during the 1930s and 1940s, placed significant blame on banks for the Great Depression. In particular, he despised the short-term debt contracts used in the banking industry. As he put it,
” … the economy becomes exposed to catastrophic disturbances as soon as short-term borrowing develops on a large scale … short-term obligations provide abundant money substitutes during booms, thus releasing money from cash reserves; and they precipitate hopeless efforts at liquidation during depressions … it must be accounted one of the most unfortunate effects of modern banking that it has facilitated and encouraged the growth of short-term financing in business generally.”
He was the primary voice behind the so-called “Chicago Plan,” which was a plan to require banks to hold 100% reserves behind deposits. In other words, when you put your money in the bank, the bank can only buy assets that can be easily converted into cash if you choose to withdraw your deposit. The assets would be primarily U.S. Treasuries. In such a world, of course, deposit-taking institutions would not be able to lend your deposits out, because most loans by their nature are illiquid and not easily converted into cash.
This argument highlights the two distinct businesses of banks. On one hand, people put their money in banks as deposits. The withdraw those deposits when they need cash, and they write checks against those deposits. On the other hand, banks use those deposits to make loans. The Chicago Plan at its core was an attempt to prevent the same institution from undertaking both activities.
There are arguments that both activities belong in the same institution: banks should take deposits and make illiquid loans. One such argument is that a fragile capital structure helps reduce agency problems inherent in making illiquid loans (although there is not much direct evidence for this). Another is that deposits are “sticky”, which gives a natural advantage to banks in holding illiquid assets (although the latter argument seems to depend crucially on government-provided deposit insurance). According to these views, deposit-taking and lending belong under the same roof.
Simons didn’t see it that way. In fact, his argument was that deposit-taking and lending were fundamentally different businesses, and that we would all be better off if we separated them. He viewed the combination of deposit-taking and lending within the same institution as “uneconomical.” As he wrote, ” … services to depositors surely could be rendered more cheaply by specialized enterprises.” Imagine banks that competed for your deposits as their core business, where they simply invested your deposits in government debt. That might mean better ATMs, better treatment when trying to access your funds, and a wider set of services.
Further, he believed that separating the lending part of banks from the deposit-taking would lead to huge advantages on the lending/investing side: “if banks as lender-investors were disassociated from banks as depository-clearing agencies, the lender-investor enterprises would focus upon a vital and essential function of providing long-term capital and, at best, of providing it in equity form. There [would then be] little need for the old type of bank lending or the short-term commercial loan.”
To us, this is the most interesting argument that Simons makes. Essentially, he argues that too much short-term debt exists in the economy because banks combine deposit-taking and lending. If you disallowed banks from lending and deposit-taking, “investment trusts” would emerge that were funded by equity, and they would have a longer-term and more productive relationship with the companies in which they invest. His “investment trusts” don’t sound too different than venture capital private equity funds, which are funded with equity and invest in the equity of start-up firms.
As Simons put it, in such a system, “Established enterprises [would] no longer need place their working capital precariously on call; they [would] finance out of withheld earnings by issuing stock rights or by outright sale of shares (or bonds) … New … businesses need long-term funds, and equity capital above all. Trading on a shoestring of equity, and under a mass of current liabilities, [would be] largely a thing of the past and should be for banks as well as for their corporate customers.”
In his view, 100% reserve banking would not only prevent dangerous bank runs, but it would also bring down the overall level of debt used throughout the economy.
Note: all of these quotes are from Simons, Henry C., Economic Policy for a Free Society, University of Chicago Press, 1948.