Simple banking is definitely the answer. You may or may not recall that the three arms of "banking" (banks, insurance, investment) were kept legally separated for a reason. There is conflict of interest otherwise. Deregulation and loosening of the existing regulations has done away with this separation. So, now we have the predicament that @edbikerii describes.
However, to TT's original question: the borrow/lend cycle includes several other key players, not just the lender, bank and borrower anymore. So it isn't just deposits and commodity collateral covering loans like it was in 1929.
Person A wants loan for $100K
Bank loans $100K at "prime+ plus its reserves.
Bank goes to Central bank and borrows $100K at "prime" minus, to replenish reserves. The spread is profit on the loan. The more the bank writes the larger the profit.
Person B deposits $10K
Bank borrows from depositor and pays a demand loan at "prime" minus minus.
In the past banks were required to have 50% reserves from deposits (cheapest form of borrowing for the bank). Through easing of the regulations, today they require about 10%. See the problem shaping up?
In this scheme, As long as 1 in every 3 borrowers paid, the bank made profits (67% defaults could be tolerated). As a result of easing only 1 in 10 defaults could be tolerated.
Banks could not insure before. Insurance is a bet. Through deregulation, today they can. This is real risk, unlike borrowing/lending on deposits. To offset this real risk, banks took side bets against their own failure. They wouldn't need to do this if their reserves were high enough, like the insurance companies are required to set aside. Instead banks were allowed to use their deposit reserves when considering insurance reserves (Yes, required deregulation). Suddenly only 1/3 defaults could be tolerated because some of the reserve was used to pay insurance risk (claims). We're down to 1 in 30 defaults. If the value of the insured items kept rising, then insurance premiums could keep rising to cover the additional exposure. Do you see the next problem shaping up?
The third leg is investment. This is even riskier than insurance. No reserves are needed. Investment brokerage relies on insurance in the form of bundled securities. It sells these to banks. If its already is a bank, it sells them to itself. The buyer needs a reserve to handle the risk, but is not required to do so, because the paper purchased is not a "loan" or "insurance". See the third problem shaping up? Now the default tolerance is about 5-10% of the base, depending on how much investment risk the bank has purchased. We are down to 1 in 200 to 1 in 300 tolerance for defaults.
Up to now, the leverage I've described had been based on reserve. The final nail in this coffin is "creative" leverage. Only investment houses could use other kinds of leverage, such as futures, puts, stays, and other "derivatives". Derivatives (creative word for scary-a$$-risk bet) were nearly unlimited in the amount of potential loss and of course the flip side, obscene gains. The loss or gain is not just the amount invested. but, usually 100 - 1000 times the amount invested, sometimes much more. If you put your reserves on the line using derivatives you would need 100 - 1000x the amount purchased. Deregulation helped banks avoid this problem by artificially "separating" the investment arms from the banking arms of banks (like drawing a line on the bedroom floor and saying to your spouse "you stay on your side and I stay on mine"). To offset this really scary risk, banks with the aide of rating agencies hid the real risk, and sold it off under the banner of "low risk" reinsurance. As long as the gain-side kept materializing as commodities rose, this wasn't questioned too deeply. This just spread the scary-a$$ stuff around the world and under cover. In many countries this would be illegal. It sure is unethical at the least. (Thank you American banks!). The final nail really just meant default tolerance on reserves went down to about 0.1% or lower. That is about 1 in 1000 loans could default before the banks started to draw on reserves. Which meant that if you are using mortgage reserve as the only reserve, then only about 1 in 2000 to 1 in 20,000 defaults could be tolerated.
Since the mortgage is the key driver of this credit bubble and housing the key commodity everyone is betting-on. As long as there was no reason for mortgage holders to default en masse, there was no problem. The reason came when a little sanity exposed just how overinflated the housing commodity really was. Unfortunately, defaults today are running at 4% (last I heard). Which means the banks are bleeding off their reserves at 400-800x more quickly they can be replenished - this means bankruptcy, and all the cards come down.
Footnote: My percentages may not be exact, but the key point is that with each step in deregulation the pressure on mortgages to shore up banks rose exponentially, exposing banks to huge losses should that one commodity ever fall. Too much leverage against a purposefully hidden risk.
So how would you fix this? With more deregulation?
