Diamond and Dybvig claim that given an attempt to impose full reserve, fractional reserve type activities (i.e. money creation) would just migrate to the shadow bank sector (see section III of their paper).
Well the simple answer is to regulate shadow banks!! Or in the words of Lord Turner (head of the UK’s Financial Services Authority) "If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safe-guards."
However, DD seem to think it would be impossible to regulate shadow banks. They say “…it will be impossible to control the institutions that will enter in the vacuum left when banks can no longer create liquidity”.
Exactly where the difficulty is, DD don’t say. But there is a good reason for thinking it would not be too difficult, as follows.
The larger a shadow bank, the more difficult it is for it to escape being noticed by the authorities and thus being regulated. On the other hand the smaller it is, the more difficult it is for it to create money.
To illustrate, any self-employed plumber or electrician with a turnover of say £100,000 who tries to avoid being noticed by the tax authorities is liable to be caught out. And £100,000 a year is a minute turnover for a bank (shadow or formal). Thus keeping tabs on shadow banks, with the possible exception of the very smallest ones, should not be difficult.As readers will have noticed, DD imply that small banks (particularly small shadow banks) can create liquidity with much the same ease as large banks. Not true.
Small shadow banks have no problem in competing with large banks when it comes to what is perhaps the main activity of all banks: connecting borrowers to lenders. But that of itself does not create money.
Creating liquidity, or at least one form of liquidity creation is the bog standard money creation business which commercial banks carry out: lending money into existence. Or as Mervy King put it, “When banks extend loans to their customers, they create money by crediting their customers’ accounts.”
Money creation consists of persuading one’s creditors to accept one’s liabilities and pass them from hand to hand in payment for goods and services or anything else. A Minsky put it, “everyone can create money; the problem is to get it accepted”. And the smaller a bank, the less easy is it for the bank to “get it accepted”. To illustrate, everyone in the UK has heard of say Lloyds bank and readily accepts a cheque drawn on Lloyds (assuming they trust the drawer), and readily accepts plastic cards with “Lloyds Bank” or “Visa” imprinted on the card.
In contrast, small shadow banks just don’t issue cheque books or plastic cards: if they did, they would not be readily accepted.
And as to other liabilities that banks issue and try get accepted as money, the smaller the bank, the more difficult it is for it to get its liabilities accepted as money.
Conclusion. The basic flaw in the DD idea that shadow banks can create money is thus. The larger a bank the more readily it can create money, but the less easy is it for the bank to escape being noticed by the authorities and being regulated. On the other hand small banks MAY BE ABLE to escape being noticed, but small banks have problems creating money.
Another form of liquidity creation is maturity transformation (MT), that is “borrow short and lend long”.
But that is another area where size pays. MT relies on calculating what proportion of depositors are likely to withdraw their deposits in the next week or month, and keeping that money available for those depositors, while lending on the rest of the money.
Now a bank with hundreds of thousands of depositors can calculate very accurately what proportion of depositors are likely to withdraw in the next month. But the same does not apply to a very small bank with say ten depositors (or similar types of bank creditor). The latter sort of bank would probably run a risk if it engaged in any MT.