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

Mentre sembra iniziare la ripresa delle economie dalla grave fase di crisi, i policymakers devono chiedersi quali riforme del sistema finanziario siano da intraprendere per cercare di prevenire la ricorrenza di simili crisi nel futuro. Ciò che dai legislatori ci si può ora attendere è l’approvazione di misure dirette ad aumentare la regolamentazione e la vigilanza sul sistema. Scopo di questo articolo è quello di spiegare e valutare una proposta di riforma alternativa che aiuterebbe a mitigare le contraddizioni risultanti dal conflitto tra obiettivi di breve e di lungo termine. Questa proposta, conosciuta come “narrow banking” (banca a operatività limitata) prevede che la narrow bank detenga i propri depositi in riserva presso la banca centrale o li investa in titoli di Stato a breve, mentre la funzione creditizia sarebbe svolta da istituti separatamente capitalizzati. La proposta mira dunque a regolare e a controllare separatamente le diverse funzioni delle istituzioni bancarie: quella di fornire un sicuro e stabile sistema di pagamenti, e quella di creare credito per l’economia. Il nucleo della proposta consiste nel rendere i depositi bancari a vista (checkable deposits) un mezzo di pagamento altrettanto sicuro come le banconote in circolazione emesse dalla banca centrale, ma senza la necessità di quella elaborata e intrusiva struttura di regolazione e vigilanza, che è necessaria quando la protezione del sistema bancario è data da forme di pubblica garanzia dei depositi e dall’accesso al credito d’ultima istanza della banca centrale.

As recovery from the present economic crisis begins, policymakers must address what reforms will be made in financial system in order to prevent the reoccurrence of a similar crisis in the future. In formulating these reforms, policymakers will also have to address the heightened moral hazard and broadened “too big to fail” associated with the bailouts of financial firms. A debate is underway in several countries about reform of regulation and oversight. Will these reforms invite regulatory avoidance behavior by financial institutions or will financial innovation be stifled? These are the important questions that must be answered by any proposal for reform. The purpose of this article is to evaluate an alternative proposal that would help mitigate the policy conundrum that often results from conflicting short-run and long-run policies. This proposal, known as “narrow banking,” would separately regulate and supervise the role of banks in providing a safe and stable means of payment from the system of credit creation by financial institutions. The heart of the proposal is to make checkable (demand) deposits as safe a means of payment as currency issued by the central bank, but without the need for the elaborate supervisory and regulatory structure required when the public deposit insurance and the discount window are part of the financial safety net. The proposal is intended to provide a safe payments system and reduce the economic need, and therefore the political pressure, to bailout large financial holding companies.

What caused the present crisis?
The financial system has become characterized by both a blurring between credit (loans) and securities and the less perceptible differences between bank and non-bank financial intermediaries. Banks remain crucial as deposit-takers with access to the central bank’s liquidity, but their involvement in the process of credit creation, as a transaction-oriented activity, has notably changed. More and more, the traditional distinction between commercial banking and investment banking has given way to another distinction, between retail banks and banks as corporate finance providers, where any activity of business financing (loans, securities, derivatives) is carried-out in a kind of universal banking scheme that may differ from country to country but is essentially the same. On the liabilities side, deposits, which in previous decades were the almost exclusive source of funds, have had a diminishing role in bank funding. Banks, therefore, appear to be exposed to unexpected changes in conditions in the volatile wholesale market, increasing the possibility of bank runs by depositors. International connections on the wholesale market only enhance the fragility of this business model. The gap between bank lending funded by deposits and total lending by banks has increasingly been funded in the wholesale market.
In the current turmoil, what seems to be emerging is that the system cannot avoid bank runs without a substantial expansion of the government guarantee and a huge potential cost to the taxpayer; and that even non-bank institutions can be too-big, or too-interconnected to fail. The wholesale market, in a global financial system, has assumed a paramount importance for maintaining stability.

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.

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