Narrow Banking Research Articles

Should Banks Be Narrowed?

Over the past 70 years, a proposal to narrow the scope of banks has emerged more and more frequently in financial debates and research. Narrow banking would prevent deposit-issuing banks from lending to the private sector and restrict nonbank intermediaries from funding investments with demand deposits. Proponents of narrow banking defend it as a step toward greater financial stability and efficiency. This study reviews the literature on the subject, contrasts the concept of narrow banking with contemporary banking theories, and evaluates the potential effects of narrow banking on finance and the real economy. The study also delineates an empirical exercise to estimate the costs of bank narrowness and draws policy conclusions based on those estimates.

The Role of Non-Bank Financial Intermediaries in Propagating Korea's Financial Crisis

The Korean crisis has been analyzed for the causal role banks played through the "credit view". Non-bank lenders have grown more important than banks in providing loans, but their role in creating financial instability has been ignored. This paper fills this gap, and demonstrates that non-banks were an important source of dislocation. Moreover, these results offer a counter-argument to proposals for "narrow banking". Narrow banking would separate deposit taking and lending into two enterprises, hopefully reducing vulnerability to panics. The poor performance of non-bank lenders even relative to banks in the Korean episode casts doubt on this model.

Illiquid Banking vs. Narrow Banking

The current narrow banking proposal begins by observing that the magnitude of safe short term assets held outside the banking system exceeds the magnitude of banks' demand deposit liabilities and then argues problems associated with illiquid banking can be avoided by requiring demand deposits be backed by safe short term assets (see e.g. Wallace [1996]). In this paper it is established that, although inefficient, the observation of safe short term assets outside an illiquid banking system does not justify the introduction of narrow banking. It is shown that illiquid banking has the potential to improve welfare relative to direct investment in available assets (autarky) whereas narrow banking does not. It is also shown that an illiquid banking system, which includes a mechanism that facilitates the transfer of liquidity among banks, can always increase welfare relative to autarky and the outcome is efficient if the return on demand deposits is sufficiently high. Three policy implications for illiquid banking follow from the results obtained. One, design of the mechanism which facilitates the transfer of liquidity among banks is crucial. Two, restricting returns on demand deposits can be undesirable. Three, deposit insurance is not required to deal with the problem of uncertain withdrawals faced by individual banks.

Lessons from the Russian Meltdown: The Economics of Soft Legal Constraints

On 17 August 1998, Russia abandoned its exchange rate regime, defaulted on its domestic public debt and declared a moratorium on all private foreign liabilities, which was equivalent to an outright default. The depth and speed of the Russian meltdown shocked the international markets, and precipitated a period of serious financial instability. Important lessons on issues of bank supervision and international stability can be learned by understanding the roots of such a crisis. The visible reason of the crisis was an unsustainable fiscal deficit coupled with massive capital flight, but what were their underlying causes? We argue that the structure of individual incentives in a context of capture of state decisions by special interests, compounded by a rouble overvaluation driven by exceptional international support, helps to explain the build–up of non–payment, theft and capital flight that led to the crisis. We offer an explicit model of rational collective non–compliance, cash stripping and rational collective non–payment which led to the fiscal and banking crisis and, ultimately, to a complete meltdown. In our view, the banking sector was already insolvent prior to the crisis, and contributed directly and indirectly to it. We conclude with a radical policy proposal for a stable banking system for Russia, appropriate for its current capacity for legal and supervisory enforcement. It is based on a segmented, narrow banking sector, concentration in commercial banking and a cautious extension of deposit insurance.

Banking in a theory of the business cycle: a model and critique of the Basle Accord on risk-based capital requirements for banks

This paper presents a theoretical framework for understanding the investment decisions and financing decisions of financial and non-financial enterprises over the business cycle. At the core of this theoretical framework is an agency problem between relatively more risk averse depositor/bondholders and relatively less risk averse stockholders. The solution to this agency problem is a corporate governance system that takes the form of an up-front contract that directs managers to make portfolio/investment decisions in the interest of their stockholders, and financing decisions in the interest of their depositor/bondholders. This enables depositor/bondholders to offset any risk shifting portfolio/investment decisions made on behalf of the shareholders thereby mitigating the moral hazard problem among debtors and creditors. The Basle Accord on risk-based capital requirements for depository institutions is one particular regulatory application of this more general theoretical framework. The paper concludes with a comparison between the Basle Accord and the 100% reserve or narrow banking proposal as the means of achieving a risk-free medium of exchange and a financial system that facilitates the optimal transfer of resources from savers to investors consistent with society’s aversion towards risk.

Can money market mutual funds provide sufficient liquidity to replace deposit insurance?

Narrow banking is an arrangement in which deposittaking and lending functions are separated and performed by different institutions. This separation is aimed at avoiding panics at uninsured banks, without moral hazard associated with deposit insurance. Money Market Mutual Funds (MMMFs) are promoted as replacements for bank deposits. For MMMFs to compete with banks, they must be able to withstand a monetary shock without losing shareholders in a flight to quality at government-insured institutions. VAR analysis indicates that MMMFsincrease share issue subsequent to a monetary tightening. This bolsters the case that liquidity can be provided in a narrow banking framework.

Banking Crises Under Soft Legal Constraints Lessons from the Russian Meltdown

On August 17, 1998, Russia defaulted on its domestic public debt, declared a moratorium on the private banks' foreign liabilities which was equivalent to an outright default, and abandoned its exchange rate regime. The depth of the Russian meltdown shocked the international markets, and precipitated a period of serious financial instability. It is important to understand the roots of such a crisis to learn about possible lessons on both issues of bank supervision and international stability. While the visible cause of the crisis was an unsustainable fiscal deficit coupled with massive capital flight, the critical question concerns the origin of such circumstances. This paper argues that the structure of individual incentives in the Russian legal context, compounded by the exceptional support granted by international institutions to Russia, explains the cycle of nonpayment, capital flight and fiscal unbalances leading to the dramatic 1998 crisis. We offer an interpretative model of noncompliance, cash-stripping and rational collective nonpayment which led to the fiscal and banking crisis and ultimately to a complete meltdown. In our view, the banking sector was already insolvent prior to the crisis, and contributed directly and indirectly to it. The last section of the paper puts forward a radical medium-term policy proposal for a stable banking and payment system for Russia. Russia needs to create a basic foundation for savings and intermediation by asset restrictions and market segmentation, crude but effective rules used in all underdeveloped systems to restrain asset stripping and opportunism. Concretely, we propose a cautious extension of deposit insurance away from the monopolistic Sberbank and towards a narrow banking layer. The proposal also proposes measures to restore charter value in the commercial banking sector.

Should Banks Be Narrowed?

Over the past 70 years, a proposal to narrow the scope of banks has emerged more and more frequently in financial debates and research. Narrow banking would prevent deposit-issuing banks from lending to the private sector and restrict nonbank intermediaries from funding investments with demand deposits. Proponents of narrow banking defend it as a step toward greater financial stability and efficiency. This study reviews the literature on the subject, contrasts the concept of narrow banking with contemporary banking theories, and evaluates the potential effects of narrow banking on finance and the real economy. The study also delineates an empirical exercise to estimate the costs of bank narrowness and draws policy conclusions based on those estimates.

Should Banks Be Narrowed?

Over the past seventy years, the proposal to narrow the scope of banks has occurred more and more frequently in financial debates and research. Narrow banking would prevent deposit-issuing banks from lending to the private sector and restrict nonbank intermediaries from funding investments with demand deposits. Proponents of narrow banking defend it as a step toward greater financial stability and efficiency. This study reviews the literature on the subject, contrasts the concept of narrow banking with contemporary banking theories, and evaluates the potential consequences of narrow banking on finance and the real economy. The study also runs an empirical exercise to estimate the costs of bank narrowness and draws policy conclusions.

Credit Markets and Narrow Banking

Maurice Allais's view that the credit created by fractional reserve banking is equivalent to counterfeiting has led him to recommend the separation of the depository and lending functions of banks. This proposal has recently been reintroduced by James Tobin and others under the term narrow banking. Proponents cite the potential for enhanced safety of the payments mechanism and the elimination of costs associated with the preses system of Federal deposit insurance. This plan resembles the reserves and proposals submitted by Irving Fisher, Henry Simons, and others in the 1930s. The essence of banking today is that banks borrow short and lend long, while Allais's proposal would require the reverse: borrow long and lend short. Among Allais's objections to the fractional reserve system are the creation and destruction of money by private banks, the impossibility of control over the credit system, and the lack of efficient control of the aggregate money supply. The fundamental principles guiding reform are that (i) the creation of money should be the business of only the state, and (ii) no money should be created outside the monetary base, so that no one would be entitled to the benefits that attach to the creation of bank money. A corollary to this proposal is that the availability of credit is limited to just what the private sector is willing to lend on an equity basis. Phillips addresses the common shortcomings of previous reform proposals (e.g. Peel's Act of 1844 and 100% reserve plans of the 1930s), which failed to recognize the existence of substitutes to banknotes and demand deposits. The lingering question is how to construct financial institutions which do not impede the development of the economy, yet are flexible enough to allow for technological innovation and market discipline. Narrow banking is a response (though not a panacea) to this dilemma, which clarifies the fundamental principles involved and allows a way out of the Federal deposit insurance mess.

Narrow Banks: An Alternative Approach to Banking Reform

Recent banking problems have prompted a variety of proposals for reforming deposit insurance and the banking system. Nearly all of these proposals, however, suffer from a common flaw - they would fail to create a banking system that is both stable and free to respond to market forces and financial developments. Narrow banking offers a possible means for accomplishing these objectives. Narrow banking would create a stable payments system by backing transaction deposits with only those assets that are truly appropriate for this task - marketable securities with virtually no interest rate or credit risk. As a result, narrow banks would essentially be fail-safe institutions and could operate without the inherent weaknesses of the current system. They would not pose a risk to depositors, taxpayers, or federal authorities and, unlike commercial banks, would not require extensive governmental support and intervention. These features of narrow banks would allow market forces to guide everyday banking decisions and the activities of any affiliated firms, thus returning the market to its proper role in allocating financial services. In many respects, narrow banking mirrors another banking reform that took place in the 1860s - the use of U.S. Government securities to back national bank notes. This earlier reform and the following change to Federal Reserve Notes collateralized largely by U.S. obligations have produced a stable currency and ended any public concern about its acceptability. This success provides strong evidence that narrow banking is a workable system that could stabilize our deposit system and its transactions function. Narrow banking, much like this earlier reform, appears to involve a dramatic change in the banking system. However, recent financial trends are making narrow banking a less radical change than commonly believed. In addition, most of the other approaches to recent banking problems entail a movement toward greater regulatory and governmental control of our financial system and its credit allocation functions - a response that is unlikely to make banking a vibrant, competitive industry. All of these factors thus suggest that narrow banking deserves careful consideration in efforts to reform the financial system.

Banking in a Theory of the Business Cycle: A Model and Critique of the Basle Accord on Risk Based Capital Requirements for Banks

This paper presents a theoretical framework for understanding the investment decisions and financing decisions of financial and nonfinancial enterprises over the business cycle. At the core of this theoretical framework is an agency problem between relatively more risk averse depositor/bondholders and relatively less risk averse stockholders. The solution to this agency problem is a corporate governance system that takes the form of an up-front contract that directs managers to make portfolio/investment decisions in the interest of their stockholders, and financing decisions in the interest of their depositor/bondholders. This enables depositor/bondholders to offset any risk shifting portfolio/investment decisions made on behalf of the shareholders, thereby mitigating the moral hazard problem among debtors and creditors. The Basle Accord on risk-based capital requirements for depository institutions is one particular regulatory application of this more general theoretical framework. The paper concludes with a comparison between the Basle Accord and the 100 percent reserve or narrow banking proposal as the means of achieving a risk-free medium of exchange and a financial system that facilitates the optimal transfer of resources from savers to investors consistent with society's aversion towards risk.

Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking

Loans are illiquid when a lender needs relationship‐specific skills to collect them. Consequently, if the relationship lender needs funds before the loan matures, she may demand to liquidate early, or require a return premium, when she lends directly. Borrowers also risk losing funding. The costs of illiquidity are avoided if the relationship lender is a bank with a fragile capital structure, subject to runs. Fragility commits banks to creating liquidity, enabling depositors to withdraw when needed, while buffering borrowers from depositors' liquidity needs. Stabilization policies, such as capital requirements, narrow banking, and suspension of convertibility, may reduce liquidity creation.

Deposit Insurance, Bank Incentives, and the Design of Regulatory Policy

This study analyzes alternative bank regulatory polices within a theoretical framework that can encompass many policy design issues. Consequences of generalizing banks' investment and financing opportunities for results in the existing literature are examined. Under costless equity issuance, a narrow banking requirement costlessly resolves moral hazard and insurance pricing problems addressed in the literature. With costly equity, minimum capital requirements can be effective but optimal policy design is complicated by its dependence on equity issuance costs, heterogeneous bank investment opportunities, and the information requirements these dependencies create. Incentive compatible policy mechanisms appear limited in their ability to resolve the information problems.

Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking

Both investors and borrowers are concerned about liquidity. Investors desire liquidity because they are uncertain about when they will want to eliminate their holding of a financial asset. Borrowers are concerned about liquidity because they are uncertain about their ability to continue to attract or retain funding. We argue that financial intermediation can resolve these liquidity problems that arise in direct lending. Banks enable depositors to withdraw at low cost, as well as buffer firms from the liquidity needs of their investors. We show the bank has to have a somewhat fragile capital structure, subject to bank runs, in order to perform these functions. A number of institutional features of a bank are therefore rationalized in the context of the functions it performs. This model can be used to investigate important issues such as narrow banking, and bank capital requirements.

Deposit Insurance, Bank Incentives, and the Design of Regulatory Policy

This study analyzes alternative bank regulatory polices within a theoretical framework that can encompass many policy design issues. Consequences of generalizing banks' investment and financing opportunities for results in the existing literature are examined. Under costless equity issuance, a narrow banking requirement costlessly resolves moral hazard and insurance pricing problems addressed in the literature. With costly equity, minimum capital requirements can be effective but optimal policy design is complicated by its dependence on equity issuance costs, heterogenous bank investment opportunities, and the information requirements these dependencies create. Incentive compatible policy mechanisms appear limited in their ability to resolve the information problems.

Narrow Banking Meets the Diamond-Dybvig Model

A version of the Diamond-Dybvig model of banking is used to evaluate the narrow banking proposal, the idea that banks should be required to back demand deposits entirely by safe short-term assets. It is shown that the mere existence of an amount of safe short-term assets outside the banking system that exceeds banking system liabilities does not make the proposal either innocuous or desirable. In fact, despite such existence, using narrow banking to cope with banking system illiquidity eliminates the role of the banking system.

Establishing Monetary Control in Financial Systems with Insolvent Institutions

The paper addresses the problem of establishing monetary control in financial systems with insolvent institutions. In particular, it examines the potential adverse selection, moral hazard, and collusion problems that can arise if indirect, auction-based monetary control systems are used in this environment. The analysis also considers the credit risks that can be assumed by the authorities when these market failures occur. The implications of using several alternative monetary control mechanisms, including a narrow banking system, the use of credit ceilings, and a two-tier banking system, are also examined.

The Role of Fixed Costs and Cost Complementarities in Determining Scope Economies and the Cost of Narrow Banking Proposals

'Narrow' banking proposals would separate insured deposits from most types of bank lending. Using data from large U.S. banks, the authors examine the extent to which narrow banking proposals are likely to result in increased production costs. Production costs will rise for nonjoint provision of deposit and loan services if there are cost complementarities in producing the two outputs jointly or if joint production enables banks to spread their fixed costs more effectively. Unlike standard cost function approaches, the authors' methods allow them to estimate the fixed-cost and cost-complementarity effects separately. They find the net production cost consequences of narrow banking to be negligible. Copyright 1993 by University of Chicago Press.

Broader Services from Narrow Banking

Broader Services from Narrow Banking