An alternative way to deal with the problems: Narrow banking
Do we need special financial institutions, such as banks, to serve both a depository and lending function? If so, then there will continue to be extensive government regulation and supervision to mitigate the effects on the economy of their illiquidity or insolvency and economic and political pressure to bailout those institutions. However, if other kinds of financial institutions could safely separate both depository and lending services, why would we need the extensive regulatory structure for banks with the large resource costs to the economy? The policy question is whether there is a way to assure a safe and stable payment system without the danger of another large taxpayer bailout. At the same time, we do not want to lose the benefits of innovation in the financial system. Narrow banking is a policy option that would strike a balance between two goals – a safety and innovation – in order to save both of them.
Though Robert Litan of the Brookings Institution was the first to use the term narrow banking, Nobel prize winning economists Milton Friedman, James Tobin and Maurice Allais supported a similar idea. As did William Seidman, Chairman of the FDIC in the ‘80s. Narrow banking would require that the money supply, M-1 = Currency + Demand Deposits, be backed by “safe assets,” most likely government securities. Until the present crisis, many central banks were effectively narrow banks because their liabilities (currency and bank reserves) were backed almost 100 percent by holdings of government debt. In the 1930s, Irving Fisher and others put forward a “safe banking” proposal that required 100% reserves held in cash or deposits at the central bank for all demand deposits.

The narrow bank can keep safe the core deposits of the banking system.  Because bank deposits are commonly used as substitutes for currency, and governments have sought to protect currency, there is a rationale for protecting bank deposits in a manner to the way currency is protected, namely, backing by safe assets. Deposit insurance, or an implicit government guarantee of all deposits for large banks (too-big-to-fail policy), is an ex-post remedy. It is based on the assumption that systemic instability consequent to a lack of government intervention in a crisis would impose a cost higher than the cost involved in the public bailing out of the institution. The idea of narrow banking would radically reverse this point of view: bank deposits must have ex-ante the same level of government protection as currency.

In summary, the implications of narrow banking are as follows:

(1) A narrow bank is more like a public utility;

(2) The impact of monetary policy on credit to the private sector would be altered and likely reduced though this depends upon whether the narrow banks invest in safe short-term government securities or are required to hold 100 per cent in central bank liabilities. If the banks hold reserves in central bank liabilities, then the M-1 money multiplier would be one. The monetary base and the basic money supply would be the same. This is the meaning of putting checkable deposits on the same level as currency.

(3) Capital requirements for a narrow bank would be reduced assuming government securities backing the narrow bank have near zero maturity;

(4) There would be less of a need for public deposit insurance other than for fraud, because the solvency of the bank would rarely be challenged.

(5) The need for the lender-of-last-resort facility comes into question. In the most extreme view, this safety net would disappear since it is not needed in the narrow bank scheme because of the safeness and liquidity of the narrow bank’s assets.

(6) Regulation of the narrow bank would be fairly simple, given its streamlined structure. More supervision, less regulation would characterize the narrow bank, but the overall regulatory burden to institutions would be reduced;

(7) Under the narrow banking proposals, private sector financing would be provided either by a “separate window” of the bank, where non-insured deposits would be collected, or by separate affiliates of the same holding company that controls the narrow bank, that may be called “finance houses”. Narrow banks could come about either through mandatory legislation or voluntary change. The “separate window” of the bank, or the separate section of the holding company (the “finance house”) could be allowed to engage in any activities, as long as there is a clear distinction, and –importantly – rigid firewalls, between insured deposits at the narrow bank, and uninsured deposits or other financial instruments.  The result would be a reduction in the regulatory burden for narrow banks while maintaining a safe and stable deposit function.

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