This chapter evaluates the usage of regulatory risk constraints as an antidote to banking panics. In particular, it considers two forms of substantive risk constraint that are widely used in financial regulation: portfolio constraints and capital requirements. It finds that these techniques, standing alone, do not provide a satisfactory answer to the panic problem. The chapter demonstrates that, at some level of stringency, such risk constraints will compromise the banking system’s ability to assist the state in achieving its monetary objectives. Furthermore, there can be no assurance that any set of risk constraints that is compatible with the state’s monetary objectives will succeed in stabilizing banking. This analysis forms the basis for a critique of various “narrow banking” proposals, which continue to claim very prominent adherents in the economics profession. The chapter also finds problems with recent proposals to impose extremely high capital requirements on banking firms. Finally, the chapter identifies serious shortcomings in laissez-faire approaches to banking, including so-called “mutual fund banking” proposals.
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