Banking Reforms for the 21st Century: A Perfectly Stable Banking System Based on Financial Innovations


  • * This paper started as joint work with Merton Miller based on our meeting with the Hong Kong Monetary Authority. This version of the paper was completed after Merton Miller passed away and the current authorship reflects the wishes of his estate. We thank Jeremy Berkowitz, Bruce Brittain, Yuk-shee Chan, Ellen Chen, Stijn Claessens, Doug Diamond, Greg Duffee, Eugene Fama, Jie Gan, Vidhan Goyal, Diane Lam, Marie Lam, Steve Lang, Andrew Lui, Elaine Ng, James O'Brien, David Stanley, Neal Stoughton, Juichi Takeuchi, Lee Thomas, Powell Thurston, Irene Tsao, Ram Willner, Patrick Wright, Michael Ye and seminar participants at the Bank of Finland, HEC, INSEAD, Swedish School of Economics and Business Administration, Hong Kong University of Science and Technology and UC Irvine for helpful comments, Moody's and Standard and Poor's for generously sharing their data bases, and Daniela Balkanska and Gaiyan Zhang for research assistance.

Nai-fu Chen
Merage School of Business
University of California
CA 92697


Although bank loans themselves are somewhat illiquid because of private information, most of their cashflows are not. Recent financial innovations allow commercial loans to be liquefied via credit derivatives and actual and synthetic securitizations. The loan originating bank holds the remaining illiquid equity tranche containing the concentrated credit risk, private information rent and the ‘excess spread’ that incentivize the bank to continue to monitor and service the loans. Empirically, we find that the average size of the equity tranche is about 3% for the representative commercial loan portfolios in our sample. The liquefaction of bank loans makes possible a banking system that restricts the guaranteed accounts to be backed by 100% reserves and the non-guaranteed deposits to be backed by liquid securitized loan tranches, while retaining the deposit-lending synergy. Such a system is perfectly safe without deposit insurance and it renders banks bankruptcy-remote without sacrificing a bank's traditional role as a financial intermediary.