Remedy for Banking Crises: What Chicago and Islam Have in Common
22 Pages Posted: 17 Apr 2018
Date Written: March 1, 2004
We document banking system instability arising from a combination of fractional reserve requirements, deposit insurance and moral hazard by presenting several episodes of severe banking distress and crises in Asia. Following a framework of functional perspective suggested by Merton and Bodie (1993), we argue that one hundred percent reserves, “narrow banking,” provides a basis for banking reform and an alternative to reduce the likelihood of systemic financial crises. Both the narrow banking and the Islamic system (equity-based systems) provide more stability to a banking sector than a conventional banking system does. Moreover, the interlinkages of financial markets and the scope for instantaneous reversal of capital flows carry potentially huge systemic risks that could prove costly in terms of economic growth and welfare.
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