if it is thought that a 25% or so capital ratio really DOES MAKE banks entirely safe, then there is no difference between the risk run by bank shareholders and depositors. That is, shareholders and depositors essentially become the same thing. And that is what full reserve consists of: it is a system where only shareholders fund lending entities / banks
Pointer from John Cochrane.
The way I think of this is that there are several ways that people take positions in bank assets. You can be an insured depositor. You can be an uninsured creditor. You can be a shareholder. And you can be a taxpayer who sometimes takes part in bailouts.
As the bank’s capital requirements go up, some of the uninsured creditors and insured depositors have to be induced to become shareholders and/or the bank has to hold fewer assets. Unless the bank is able to offset these effects by taking on higher risk, this will reduce the value of the subsidy provided by taxpayers.
It is my view that relatively few people want to hold mutual funds that invest in risky projects. They would prefer instead to be insured depositors. They probably are willing to collectively provide insurance. However, in practice, the government ends up eager to bail out not only insured depositors but uninsured creditors and often shareholders as well.
There is a practical threshold as well as outer limits and philosophical thresholds. The philosophical one is that you shouldn’t promise to pay if when it is needed is the time it won’t be there.
The other limits involve diversification and correlations.
I wonder, since housing prices were were bid up, and banks were ujdiversified whether a nominally riskier investment portfolio would have headed off the crisis.