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Narrow Banking: A Proposal to Avoid the Next Taxpayer Bailout of the Financial System

di - 12 Ottobre 2009
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Objections to the Narrow Banking Proposal
Numerous writers have put forth objections to the narrow banking proposal. Critics argue that the credit to the economy would shrink and be therefore more costly, and that rather than eliminating systemic risks, embedded in the scheme is a potential systemic instability. In simple terms the problem arises because the ability of narrow banks to create money would be constrained (though as noted, this depends upon whether bank deposits are backed by government debt or central bank liabilities). The finance houses, in order to extend an equal amount of credit as a conventional bank, would need to attract more customers’ funds by a higher remuneration than that paid by a conventional bank on insured deposits. Finance houses could create financial assets that are close substitutes for money, but the important point is that they would not have deposit insurance.

If we counterbalance safe deposits at the narrow bank to less protected financial instruments at the finance house, letting the finance house fail would raise concerns when its situation deteriorates, possibly causing a flight to safety into the narrow bank. The deposit/other credit instruments ratio would increase abruptly (a concern strongly signaled in the past by Friedman). A key-goal of the narrow bank concept – to shrink the scope of the taxpayer safety net – would be defeated, if the government were “obliged”, because of systemic preoccupations, to open the discount window to stabilize the outflow from the finance house .

More importantly, we are accustomed to associate systemic risk with the typical commercial bank structure: not by chance, the US federal safety net, or similar institutional arrangements in other countries, was restricted to that structure, in the belief that other, riskier financial activities could well deal with their problems, while the government intervention was mostly confined to the conduct-of-business/transparency supervision, enacted by a separate authority

Reform of the financial system is once again on the agenda for international bodies and national legislators and regulators as well. Bankers are rightly concerned that a return to New Deal-style regulation, while solving some immediate problems, may adversely affect banking operations in the long run. At the same time, the public is concerned about the safety and security of their money and their savings. While regulation of narrow banks could be reduced, it would not mean the end of all financial system regulation, because regulation of lending or transaction-oriented institutions should continue. However, if the only insured deposits are in narrow banks, then the potential costs to the public purse would be greatly reduced. Though deposit insurance is redundant for narrow banks, it could be maintained with reduced premiums.

Should government policy attempt to maintain the current role of banks in offering deposit and lending functions with federal deposit insurance or begin the evolution toward a financial system that separates the respective banking functions? A narrow banking system would not only protect depositors and forestall future bailouts, but also create a way for bankers to compete in other areas without being hindered by too intrusive regulatory burdens.

Fisher I., 100 per cent Money, Adelphi, 1935
Friedman M., A Program for Monetary Stability, in Kendall L.T., Ketchum M.D. (eds), Readings in Financial Institutions, Houghton Mifflin, 1965 (Friedman’s Program was first published in 1959)
Litan R.E.,What Should Banks Do?, The Brookings Institution, 1987
Phillips R.J., Narrow Banking Reconsidered, Levy Institute Public Policy Brief, no. 18/1995
Tobin J., The Case for Preserving Regulatory Distinction, in Restructuring the Financial System, Federal Reserve Bank of Kansas City, 1987

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