We show that bankers have strong incentives, particularly in a system in which governments provide explicit and implicit guarantees to much of their debts, to choose a funding mix that is highly fragile and involves much short term debt and very little equity. These incentives, however, are based entirely on private considerations and none of them suggests that this funding mix is efficient, let alone essential, from society’s perspective. To the contrary, everything banks do, which includes taking deposits, providing liquidity and making loans and other investments, can be done even better with a funding mix that includes significantly more equity relative to debt than they have now. Such a funding mix would be safer and it would make for a less distorted system that would be less likely to harm creditors and taxpayers.
If Not Now, When? Financial Reform Must Not Await Another Crisis
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