A Guide to Banking Reform and Full-reserve (Narrow) Banking

 Overview  |  Bank failures  |  Taxpayer subsidies  |  Regulations  |  Narrow Banking History  |  Fractional-reserve Structure and History
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It is nonetheless a serious defect of our present fractional reserve system that it requires continuous jiggling of monetary tools...
...recommending that the present system be replaced by one in which 100% reserves are required.
I urge that interest be paid on the 100% reserves.
Milton Friedman, 1976 Nobel Prize laureate (from his 1959 book, Ch. 3)

The truly urgent problem, I think, is the abuse of deposit insurance.
"One-stop" banking and financial servicing is a popular slogan, but it tends to fall apart under close scrutiny.
Collecting various services under one roof will not make your visit "one-stop" except for parking your car.
"One-statement" finance is probably another mirage.
Companies owning banks must be prevented from placing the risks of their various activities on those safety nets.

James Tobin, 1981 Nobel Prize laureate (from a 1987 article)

A brief overview of this proposal

What is "narrow banking?"

The narrow (full-reserve) banking proposal  calls for a total separation of bank deposit accounts from all other bank activities to address the following issues:

  1. During the years leading to financial crises, banks lend around 90% of the money deposited in transaction accounts (such as checking) and over 95% of total deposits (savings accounts included).

  2. Banks are not required to obtain permission from depositors to lend and take risks with their money.

  3. Under this proposal, banks would be able to lend using depositors' money only after the depositors themselves choose to transfer their money to designated "lending" accounts that will be regarded as "risky" accounts (similar to mutual funds).

  4. Otherwise, depositors' money will be kept as liquid cash or deposited with  the central bank.

The term "narrow banking" was coined in Litan (1987).

What are the main objectives of narrow banking?

  1. To free taxpayers from the repeated burden of having to bailout failing banks using taxpayer money.

  2. To prevent banks from creating money. Bank money creation has been shown to amplify business cycles.

  3. To prevent banks from bundling risk with deposits.

  4. Letting depositors (not banks) make the decision  whether to risk a depositor's money. Depositors should know better what degrees of risk are appropriate for them (if any).

  5. Reducing banks' incentives to take excessive risks with depositors' money, thereby

  6. Reducing the implicit subsidies (rescue guarantees) provided to commercial banks by the taxpayer and central banks.

But, central banks argue that banks are "safe" now

What central banks attempt to do is to raise banks' capital requirement to 18%. What's odd about this is that central banks and even academia ignore the simple fact that major banks that failed in the 1930s held over 20% equity on their balance sheets, see Foroohar (2016, p.33). The evidence provided below shows that banks fail because they take risks with depositors' and other lenders' money and these risks and the resulting losses have little to do with equity shortage.  

But, why should I care? My bank is FDIC insured!

Not so fast, as it turns out, your "insurance" company does not have a lot of money. The Federal Deposit Insurance Corporation (FDIC) reports that  its deposit insurance fund has $72.6 billion, which constitutes a reserve ratio of 1.11% out of total deposits. This means that the FDIC fund can recover less than 2% of total deposits during bank failures. To obtain a rough estimate for why the FDIC becomes almost irrelevant during financial crises, each of the three-largest U.S. banks ranked by total deposits holds over $1.2 trillion ($1,200 billions) worth of deposits. More precisely, the amount of deposits held by each of the 24 largest banks in the U.S. is larger than the entire FDIC fund. 

In Europe, the Single Resolution Fund (SRF), which is the equivalent of the FDIC in the US, has a goal of reaching Euro 55b (currently it has less than Euro 20b), which is a negligible amount compared to the observed taxpayer bailouts.

Another common misperception related to the "safety" of bank deposits stems from the fact that depositors are not aware that they are not first priority in bank liquidations regardless of how much money they deposited. Bankruptcy liquidation priorities are discussed in Marino and Bennett (1999).


Fractional-reserve banking: 700 years of repeated failures

Although some forms of fractional-reserve banking prevailed even before the Middle Ages, reliable records of bank failures are available since 12th-century Europe.

In 1345, Florence's world biggest international bank (owned by the Bardi and Peruzzi companies) failed after 30 years of extensive credit extension and fictitious financial practices, resulting in a global financial collapse.

n 1584, Venice's largest bank House of Pisano & Tiepolo closed because of inability to refund depositors. The bank was made into a state bank, and then failed in 1619.  By that time, 96 banks have already failed in Venice, Roberds and Velde (2014, p.19).

In 1791, the Bank of Amsterdam was taken over by the city. Established in 1609, the original charter required the bank to make deposits redeemable on demand as a "narrow" bank, but the bank quickly began lending, Roberds and Velde (2014, p.35), Quinn and Roberds (2014, p.10). As Fisher (1936) points out, the Bank of Amsterdam in the 17th Century "...broke faith and secretly lent out some of its 100% reserves. Ultimately, this policy caused its failure..." 



In 1992, Scandinavian banks failed. The government of Sweden guaranteed all bank deposits of the nation's 114 banks and assumed some of their bad debts.



1986-1995: Total collapse of 1,043 savings and loan (S&L) associations in the U.S.

2012-2013: Cyprus' banks collapsed.

The ECB and the IMF were called to the rescue.

April 2013, big jump in the price of Bitcoin  (consumers search for "safer" store of value).


British bank failures and government bailouts: 1825, 1836, 1847, 1914, and 2007-2009.

Major U.S. banking crises: 1792, 1837, 1839, 1857, 1863, 1873, 1884, 1890, 1893, 1896, 1907, 1920s, 1930-1933, 1980s, and 2007-2009.

The chart below (source) illustrates the number of U.S. banks that failed since 1864.

As the figure shows, bank crises follow a cycle of 10 to 20 years, with the exception of the period between the 1940 to the mid-1980s (S&L crisis). The author identifies correlations between bank failures and income inequality

2007-2009: Total collapse of financial systems in the U.S. and Europe.

Picture shows a line of depositors in front of Northern Rock (British bank that was bailed out using taxpayer money).

Boyd et al. (2014) provide extensive list of bank failures in different countries. The FDIC lists 500+ U.S. bank failures since 2000.

2016-2017:  In December 2016, the government of Italy approved a taxpayer bailout of Italy's largest and oldest bank Monte dei Paschi di Siena. This would be the third time the bank is rescued using taxpayers' money. Paradoxically, Monte dei Paschi purchased consulting services from JPMorgan Chase that in 2008 was also rescued with billions of dollars of taxpayer money. In July 2017 the Italian government took control of this bank.


Taxpayer subsidies provided to banks and social costs

The big puzzle


  1. the banking industry is so unstable, and

  2. banks lend money they don't have, and

  3. maintain 10% reserves on transaction accounts, and 1% on savings accounts, and

  4. the FDIC fund is insufficient to bail out any of the 24 largest banks in the U.S.

Then,  how can it happen that...

  1. we still keep our money in the bank?

  2. banks report making profits? and

  3. senior bank managers collect millions of dollars in bonuses?

This complicated question has a simple answer: Banks rely on taxpayer-funded implicit and explicit unconditional guarantees to bail them out.

Banks all over the world operate under the self-fulfilling expectation that governments do not have the political strength to leave depositors without money after their bank fails to return their money. In addition, banks rely on low-cost services provided by central banks only to banks.

What kinds of subsidy?

Explicit and implicit public subsides provided exclusively to banks include:

  1. Ability to open accounts and safekeeping with central banks. Currently, banks in the U.S. are paid 0.25% interest on reserves kept with the Federal Reserve.

  2. Access to low-cost money transfer services, such as the automated clearing house (ACH) and FedWire (a real-time-gross settlement network).

  3. Access to discount windows providing low-cost loans to banks under the "lender-of-last-resort" paradigm.

  4. Implicit guarantees to bail out failing banks under the "too-big-to-fail" paradigm.

  5. Implicit subsidy via deposit insurance, see Calomiris and Jaremski (2016).

Economic consequences of the subsidies

Noss and Sowerbutts (2012)  explain how the implicit subsidy arises and why it remains a public policy concern. Taxpayer-provided subsidies of banks generate three types of distortion:

  1. Banks that most benefit from subsidies (large banks) enjoy a competitive advantage over those that do not. This is because creditors of these banks settle for lower interest they charge banks for bearing their risk, thereby lowering the banks' cost of funding.

  2. Taxpayer guarantees increase banks' incentive to take risks as losses will eventually be borne by taxpayers. The resulting cost to society of financial crises could far exceed the cost of the subsidy.

  3. Taxpayer guarantees of banks result in an increase in the size of the financial sector thereby diverting resources from more productive sectors of the economy.

Empirical estimations of the subsidies

Implicit subsidies of banks are hard to quantify because they are not recorded or published by governments. In fact, most taxpayers are not even aware of the subsidies they provide to banks. Therefore, the measurements of bank activities must first be extracted from hard data and only then be put into models that yield estimates of the monetary value of these subsidies.

Noss and Sowerbutts (2012)  describe the different approaches used in the literature in order to estimate implicit subsidies. The two main approaches are:

  1. Funding advantage models that determine the value of the subsidy as the aggregate reduction in the cost of bank funding due to an implicit government guarantee. Cost of funding includes interest paid to creditors.

  2. Contingent claims models that value the subsidy as the expected payment from the government to the banking sector to prevent defaults and failures.

Focusing only on the banks' cost of funding advantage aspect of the government subsidy, Acharya et al. (2015) show that the dollar value of the annual implicit subsidy accruing to major U.S. financial institutions amounts to on average $30 billion per year and rose above $70 billion during the recent financial crisis.

Moreover, Marques et al. (2013) provide international evidence on government support and risk-taking in the banking sector. They show that the provision of explicit and implicit government guarantees affects the willingness of banks to take risks by reducing market discipline. More precisely, they find that more government support is associated with more risk-taking by banks, especially during the recent  financial crisis (2009-2010).

Taxpayer and central bank direct subsidies during banking crises

So far, we have described how governments (taxpayers) subsidize banks on a daily basis by providing explicit and implicit guarantees to bail out failing banks. However, taxpayers bear additional costs during financial crises when governments actually transfer money to banks so that banks could meet their obligations to creditors and depositors. 

So how much it costs taxpayers to bail out failing banks? According to Curry and Shibut (2000), during the savings and loan crisis (S&L), 296 financial institutions with total assets of $125 billion were either closed or rescued from 1986 to 1989. In 1989, 747 additional thrifts with $394 billion were resolved. The S&L crisis had cost taxpayers $124 billion and the thrift industry another $29 billion. 

In 1992, the Swedish government guaranteed all bank deposits of the nation's 114 banks and assumed some of their bad debts. In March  2013 the ECB and the IMF arranged for a ?10 billion bailout of Cyprus' banks.

During the 2008 financial crisis the US Congress authorized $700 billion to the Troubled Asset Relief Program (TARP). In addition, the cumulative bailout commitment (asset purchases plus lending by the Federal Reserve) during 2007-2009 was $7.77 trillion (Bloomberg) and over $29 trillion according to Felkerson (2011). Initially, the Fed tried to conceal this information from the public, but later on was forced to release it after Bloomberg sued.

Oxera (2011), provides an estimation of the average taxpayer subsidy of U.K. banks in the years following the recent banking crisis. The average state support in 2009 for the top 5 U.K. banks exceeded ?100 billion, with the average per bank being around ?26 billion. This is in addition to the ?56 the banks received in 2008.

In December 2016, the government of Italy approved a ?20 billion taxpayer finance of Italy's largest and oldest bank, Monte dei Paschi di Siena. This is in addition to the ?3.9 billion received in 2013. Italy's taxpayers were already exposed to debt levels of 133% of GDP even before this bailout (second-highest  in Europe). In July 2017, the Italian government took control of this bank after injecting additional ?5.6 billion of taxpayer money.

Social costs of banking crises

The  implicit and explicit subsidies of banks constitute a small fraction of the social cost of a financial crisis. In a cross-country analysis, Hoggarth et al. (2002) estimate the cost of banking crises to be between 15% to 20% of an annual GDP. Atkinson et al. (2013) estimate the social cost of the  2007?2009 financial crisis to be between 40% to 90% of one year's output ($6 trillion to $14 trillion, which translates to $50,000 to $120,000 for every U.S. household).

Epstein and Montecino (2016) estimate social costs by analyzing three components: (a) rents, or excess profits; (b) misallocation costs, or the price of diverting resources away from non-financial activities; and (c) crisis costs, meaning the cost of the 2008 financial crisis. Adding these together, they estimate that the financial system will impose an excess cost of as much as $22.7 trillion between 1990 and 2023, making finance in its current form a net drag on the American economy.

Blyth (2013) describes how the general public and low-income families in particular got penalized for bank failures that they were not responsible for. His book argues that private debt of highly leveraged financial institutions became public debt of states. Consequently, states were pressured to implement a regime called "Austerity" that focused on cutting government services, which targeted mainly low-income families.


Do we need more regulations?

No, we don't. We need much less regulations!

As also argued in Kay (2010), bank regulations consistently failed to protect taxpayers from having to bail failed banks. And this is for the following three reasons:

1. Lobbying: It is often said that "wherever lobbying begins, capitalism ends." The graph below (source) reveals that commercial banks spend over $1 million per week on lobbying activities. 


Lambert (Forthcoming) empirically demonstrates that banks active in lobbying are 44.7% less likely to receive a severe enforcement action from the regulator. Even if Congress manages to pass laws that limit banks' risk-taking activities, as we show here, often, the key components of these laws are eventually repealed by Congress itself after banks intensify their lobbying activities.

2. Regulatory capture: Regulatory agencies have no incentives to enforce the regulations. In fact, Dagher (2018) examines booms and busts since the 18th Century and presents evidence of pro-cyclical regulatory policies by governments. Risk-taking during booms were often amplified by an increasing light-touch approach to financial supervision. Eisinger (2017) explains why the Justice Department fails to prosecute bank executives. Griffin (2010) examines the history of the Fed and its role as a protector of the interests of large banks. Jacobs and King (2016) argue that the Federal Reserve managed to overstep the U.S. constitution by giving trillions of dollars in loans to financial institutions. Haedtler et al. (2016) argued that the Fed should become fully public in order to represent the diversity of public interests.

3. Regulatory cost: Kupiec (2014) reports that the average employee compensation at bank regulatory agencies is more than 2.7 times that of private-sector bank employees. Taxpayers eventually pay the bills. Simply put, regulatory agencies are costly!

The myth behind capital requirements as a way to prevent  bank failures

 The graph below (source) depicts U.S. banks' capital to assets ratio during 1998-2015.

The graph demonstrates that even the sharp rise in the capital/assets ratio from 1998 to 2007 could not prevent the 2008 total collapse of the entire banking sector. Despite this evidence and the fact that there is no research that establishes a correlation between lack of capital and bank failures, most economists and policy makers still believe that raising the capital ratio to 18% or 25% (Minneapolis Fed), or even to include 35% equity (Admati and Hellwig (2014)) will protect taxpayers from having to bailout failing banks.

The widely publicized Basel Committee on Banking Supervision (known as Basel I, II, & III) suggests regulatory guidelines on the minimum amount of capital banks should hold. The committee recommends a minimum Tier 1 capital ratio of 6%.

As the graph shows, there is no relationship between lack of capital and the frequency of bank failures. In addition, the myth concerning high capital ratio as a cure for failures suffers from some logical problems. To see that, suppose a large bank maintains 25% equity. Then, why would equity (stock) owners have any incentives to reduce the amount of risks taken by their bank, knowing that taxpayers will always be there to rescue depositors and the bank in an event of a failure.

The bottom line, banks fail mostly because managers take risks with depositors' money, and less because of shortage of equity or capital. In fact, stock holders may want to  reward managers for taking even more risks in order to collect higher short-term returns. Or, as often observed, managers, who are rewarded based on short-term profits and then leave with a golden parachute, may act without consulting their stockholders. Moreover, during crises, the value of capital diminishes which reduces its usefulness for protecting against failures. Therefore, it is not clear how increased capital could reduce the risk of bank failures.

The Glass-Steagall Act of 1932?1935

After the vast collapse of banks in 1929, this Act gave each bank one year to decide whether it would be a commercial bank or an investment bank. Commercial banks were prevented from dealing with non-government securities for their customers and for themselves. The intent behind this separation was to restrict banks from speculating with depositors' money.

Over the years, the effectiveness of this law has diminished by actual repeals of several sections of the law, by court rulings, and by regulatory agencies that adopted weaker interpretations of the requirements intended to separate investment banking from deposit-taking banks. For example, already in the 1960s, First National City (today Citibank) has managed to bypass this law by introducing "negotiable CDs" that were traded on a secondary market which blurred the difference between deposit-taking and investment banking, see Foroohar (2016, p.46).

Finally, in 1999, during the Clinton Administration, the Gramm-Leach-Biley Act removed the remaining obstacles by allowing bank subsidiaries and bank holding companies to deal with securities. Only nine years later, in 2008, large banks sought government assistance to relieve them from a variety of "bad" securities including credit default swaps, subprime lending, and collateralized  debit obligations that lost their value in a short period of time.

The failure of the Dodd-Frank Act

 Also known as "The Wall Street Reform and Consumer Protection Act," it was signed into law on July 21, 2010, and represents the latest failed attempt to regulate banks in order to reduce their dependence on taxpayer money after the 2008 financial crisis.

Less than 5 years after the law was signed by President Obama, intensive lobbying activities of the banks led Congress to pass a Spending Bill that rolled back a rule which restricted trade in derivatives, the very financial product that helped to cause the financial crisis of 2008. This bill also removed the restrictions on the use of government money to bail out failed banks.

But, I have read in the newspaper that central banks are now taking some actions  

Here is the story: On November 9, 2015, the Financial Stability Board (FSB) has issued new guidelines on bank balance-sheets that require banks to increase their capital ratio to 16% by 2019 and to 18% by 2022. What's odd about these guidelines is that they totally ignore the fact that major banks that failed in 1929 held over 20% equity on their balance sheets, see Foroohar (2016, p.33). Banks do not fail because of lack of capital but because they take risks with depositors' money and the type of securities they trade with.

Capital ratio consists of mostly equity (value to shareholders) plus cash reserves all divided by the assets of the bank. But now, instead of calling it just capital, the regulators apply some marketing techniques and call it "Total Loss Absorbing Capacity" (TLAC), perhaps to create an impression that the taxpayer will be off the hook in future crises.

So, should we expect banks to stop failing after 2019? Wishful thinking! Even if banks will eventually comply with the TLAC requirement, the next collapse of the banking sector will require the taxpayer to be responsible for the remaining 82% of the losses (less cash reserves that banks may hold). But, these loses could be much higher because of fire sales that would further diminish the value of banks' capital during the next crisis.

More regulations versus structural change

So, if banks cannot be regulated, what else can be done? The narrow banking proposal calls for a structural change of the banking industry. Financial institutions would be split into two types:

1. "Narrow" banks where depositors are backed by 100% reserves held at central banks. Part of the interest paid by the central banks could be passed on to depositors who can use these accounts as a safe savings option.

2. Risky banks and mutual funds that may fail from time to time, where depositors (not taxpayers) would bear all the risk. Mutual funds have the advantage that they are more transparent than banks, but this may change over time as a result of competition. 


History of the narrow banking proposal

The proposal that depository institutions maintain 100% reserves goes back to the Great Depression and is attributed to a group economists at the University of Chicago. In 1933 this group wrote a memo (signed by Frank Knight) to Henry Wallace who then sent a letter to President Roosevelt. The memo describes the plan for how to guarantee bank deposits by requiring banks to maintain 100% reserves as well as the separation of the "Deposit and Lending functions of existing commercial banks." [p.3].


In 1939, a group of academic economists circulated "A Program for Monetary Reform" that also emphasized the need for 100% reserves. That policy plan was also supported by other well-known monetary economists such as Irving Fisher (who corresponded frequently with Roosevelt), Milton Friedman, and James Tobin, see Phillips (1992) and Benes and Kumhof (2012) for references and a more detailed description of the plan?s history.

According to Hart (1935), the proposal called for "the radical reform of the American banking system by requiring reserves of 100 percent against all deposits..." and had some support in the political world.

Friedman (1959, Ch. 3) adopted the Chicago plan and went even further by suggesting that interest be paid on the 100% reserves (by the Fed, or from a special budget allocated by the Treasury). According to Friedman, if the banking industry is competitive, this interest would also benefit depositors as some of the interest would pass-through on to depositors and therefore encourage savings. It would also compensate banks for their loss of revenue from having to reduce or terminate their lending activities.

In June 1934, bills were introduced in both houses of Congress requiring the "maintenance of 100 percent reserve against chequing deposits." In other words, the plans called for a total separation of the credit functions of banks from deposit-taking related services, so that all deposits would be 100% backed by government-issued money. According to Benes and Kumhof (2012), the Chicago Plan was never adopted as law due to strong resistance from the banking industry.

Quoting from Fisher (1936), Fisher?s classic endorsement of the plan:

"I have come to believe that the plan, properly worked out and applied, is incomparably the best proposal ever offered for speedily and permanently solving the problem of depressions; for it would remove the chief cause of both booms and depressions, namely the instability of demand deposits, tied as they are now, to bank loans."

On page 15, Fisher writes:
"This means that in practice each commercial bank would be split into two departments, one a warehouse for money, the checking department, and the other the money lending department, virtually a savings bank or investment bank." 

Common critique of narrow banking

Critics of the narrow banking proposal point out that narrow banking will not fix the financial sector because loans will be pushed into shadow banking which is harder to regulate.

This line of criticism is partially correct, but misses the point: Narrow banking has only one purpose: To eliminate fractional-reserve banking that has never worked and always relied on taxpayer money. By separating deposits from lending and any other financial instruments, government may finally possess the political power they need to refuse to bailout financial institutions because depositors' money will be then backed by 100% reserves. 

A second common critique of narrow banking is that the abolition of fractional-reserve banking will increase lending rates. Fractional-reserve banks are able to charge low rates because of the implicit and explicit taxpayer subsidy of banks. In fact, borrowing from banks is almost equivalent to borrowing from the government because governments don't let banks fail.  That is, the lending market is already destroyed by not creating true competition among lenders that would not favor banks. Mutual funds and peer-to-peer lending would generate  market-determined optimal lending rates, which could be higher than the ongoing rates.

Both critiques may be dismissed if all lending is shifted to mutual funds. Mutual funds in general and index funds in particular, allow investors (savers) to diversity their risk with mixed transparent portfolios. For example, mutual or a pension funds that invest 40% in treasury bonds, 25% in stocks, 25% in corporate bonds, and 10% in mortgages impose low risks on savers and are unlikely to be bailed out using taxpayer money.


Structure and history of fractional-reserve banking

Definition of "fractional reserve"

Commercial banks are often referred to as "fractional-reserve" depository institutions. The reason behind this terminology is that banks actually keep only a small fraction of depositors' money in the form of cash or in deposits held safely in the central bank. Therefore, most commercial banks are not able to meet the demand for cash withdrawals unless the withdrawals are made by a small fraction of account holders.

Moreover, fractional-reserve banks "bundle" risk with deposits by taking risks with depositors' money without obtaining any permission from depositors, Shy and Stenbacka (2000, 2008). This is not the case when people deposit money with mutual funds where they can choose the exact risk portfolio that meets their preference.

Banks' money creation: The textbook story

Most university textbooks on money and banking describe a model showing how fractional-reserve banks create money. These textbooks argue that "deposits create loans" and hence more money.

Consider an economy where banks maintain 10% reserve ratios. A person with $100 deposits the money with bank A. Bank A then lends $90 to another person, who then deposits it in Bank B. Bank B lends 0.9 x $90 = $81 to a person who deposits it in Bank C. Total money created in the economy can be computed to be:


Therefore, according to this textbook scenario, from an initial $100 deposit, the banking system has created additional $900 of inside money via loans.

The reader should bear in mind that even if that model were true, there has not been any research that managed to provide any social welfare justification for money creation by commercial banks.

Carpenter and Demiralp (2010) empirically establish that actual money multipliers tend to be volatile and often deviate substantially from the theoretical multiplier. Their Figure 1 (presented here) documents actual volatile money multipliers ranging from 5 to over 20 from 1990 to the 2008 financial crisis compared with the theoretical multiplier of 10.

A  logical problem with the standard explanation

A Bank of England working paper, McLeay et al. (2014), identifies a logical problem with the standard explanation of money creation, namely, that this explanation neglects to mention where the initial $100 came from.

The answer is that the person has probably received the initial $100 from her employer. But the employer had to get the $100 from somewhere, which means that the employer withdrew $100 from the business bank account. Therefore, the total net initial change in the money supply should be zero and not $100 (unless the central bank injects new money via an open market operation).

The main conclusion of that paper is that, contrary to the standard textbook assertion that "deposits create loans," the correct assertion should be that "loans create deposits." This means that, under the revised model, banks create even more money during economic booms, and contract faster during recessions, which explains why banks' money creation amplifies the business cycle.

The authors demonstrate their explanation with the following aggregate balance sheet of all commercial banks.

As the figure shows, new money and deposits are created at the moment the bank grants a loan to a customer. This type of deposit is often referred to as "fountain pen money" created at the stroke of a banker pen when a bank approves a loan. The former governor of the Bank of England King (2016) calls this process money "alchemy" (creating money from thin air). As we show below, taxpayers incur an additional loss of revenue (seigniorage) from letting commercial banks create money that way instead of the government or the central bank.


Fractional-reserve banking from Middle Ages Europe and the Renaissance to the United States

Fractional-reserve banking emerged in Europe during the Middle Ages by money changers. Whereas the use of coins by money changers has been a great improvement over barter trade by reducing the problem of double coincidence of wants, it was hard to maintain uniform quality of coins to represent a given unit of account.

Consequently, Middle Ages money changers quickly realized that they can open accounts and settle local transactions without the need of always giving and receiving metal coins. Because coins were needed only when depositors withdrew them, money changers began allowing some customers to overdraft their accounts. By doing so, money changers turned into fractional-reserve banks that we observe until this very day.

From the Middle Ages to this very day, depository institutions continued the practice of lending out depositors' money, thereby creating new money via the money multiplier. In addition, they create their own money.

The failure of reserve requirements

According to Feinman (1993), recognizing banks? strong incentives to lend, some states in the United States began requiring banks to maintain some reserves on deposits.

Reserve requirements were first established at the national level in 1863 with the passage of the National Bank Act, where banks had to hold a 25% reserve against both notes and deposits?a much higher requirement than that faced by most state banks. Reserve requirements were seen as necessary for ensuring the liquidity of national bank notes and thereby reinforcing their acceptability as a medium of exchange throughout the country. In 1864, the required ratio was lowered to 15%.

The Federal Reserve Act of 1913 created a system of Reserve Banks that could act as lenders of last resort by accommodating banks' temporary liquidity needs. Feinman (1993) describes the reserve requirements in that era.

As of January 2015, the ongoing required reserve ratios (determined by the Board of Governors of the Federal Reserve) are: 10% for depository institutions with net transaction accounts exceeding $103.6 million, 3% for depository institutions between $14.5 and $103.6 million, and none for depository institutions with less than that.

During financial crises, banks often argue that they fail because the economy failed. In 2008 the economy did not fail. It is the financial sector that always fail first and drags the economy with it.

Has anything changed since the Middle Ages?

Not really, since the Middle Ages, banks continued to lend money they mostly don't have. Technology may have changed, but the incentive to maximize the amount of lending has not vanished, and actually became stronger with the introduction of new financial instruments, such as subprime mortgages.

But, wait a minute, one thing did change over the years. We now have venture capital and a huge market for mutual funds. that did not exist in the Middle Ages. The mutual funds market in the U.S. has 8,000 funds (and growing) with total assets exceeding $15 trillion. Worldwide mutual fund assets now exceed $31 trillion.

The large variety of funds reflect different degrees of risk, diversification, and liquidity that savers can choose from. A large portion of these funds lend money just as banks, with the difference that mutual funds lend money they have whereas banks lend money they mostly don't have.

Perhaps the most important feature of mutual funds is that they are transparent. Each mutual fund lists its entire portfolio on the Internet so savers can switch funds whenever they want to. In contrast, banks do not tell depositors where their money goes, so depositors do not have any control over their risk.

The lack of transparency of how banks handle their depositors' money and the money they create with it reduce governments' political strength  needed for refusing to bail out failing banks, because politicians will argue that depositors cannot be "punished" for risks they did not take.

Summary: Reasons for failure and non-optimality of the system

This fractional-reserve banking system has fails for the following reasons:
(a) Banks frequently fail to fulfill their obligations to depositors unless supported by government money.
(b) Banks Rely on taxpayer money before they fail (implicit subsidies) and after they fail (explicit taxpayer subsidies).
(c) Banks bundle risk with account safekeeping and payment services. That is, banks expose depositors' money to risk without obtaining permission to do so (in contrast to mutual funds where investors can control and monitor risk taken with their money.

Can bank failures be compared with fires and car accidents?


Despite the 700+ years of bank failures, currently, the overwhelming majority of economists, policy makers, and bankers (of course) favor fractional-reserve banking over any other financial system. The most common defense of the system is the story of "fire." Although most (not all!) proponents of fractional-reserve banking do acknowledge the repeated bank failures, they tend to compare bank failures to fires and car accidents by making the following arguments: "The fact that banks fail does not imply that the system needs to be changed because the fact that we observe  fires does not imply that people should not live in houses." Similarly, "the fact that there are car accidents does not imply that cars should be prohibited to drive."

Do these arguments make sense? Not really, because most house owners try to avoid fires and most car owners try to protect their cars to avoid any accident. In fact, insurance companies place high deductibles precisely for this reason. In contrast, bank managers who make the decisions how much risk to take with depositors' money are not the owners of this money. That is, banks earn profit by taking risks with money that they do not own. Moreover, taxpayer protection of bank failures does not place any deductibles with respect to managerial compensation. In each financial crisis, bank managers receive golden parachute compensations and move on to other businesses. Putting it more formally, fractional-reserve banking tends to bundle risk with deposits without the knowledge and consent of depositors who own this money. This cannot be compared to house or car owners who themselves make all the risk decisions associated with their own  property and also bear the consequences associated with their own failures. 


Past and ongoing attempts to implement narrow banking

First known implementation of narrow banking

In 1361 Venice's Senate prohibited lending out depositors' money (thereby creating narrow banks!), Roberds and Velde (2014, p.17).

Bills submitted to Congress but failed to pass

In June 1934, with the knowledge of President Roosevelt, bills were introduced in both houses of Congress requiring the "maintenance of 100 percent reserve against chequing deposits." Senator Bronson Cutting introduced it in the Senate on June 6th, 1934 (S. 3744). Congressman Wright Patman introduced it in the House (H.R. 9855). Eventually, under pressure from banks, these two bills failed to pass.

More-recent proposals

Johnsen (2014) describes the collapse of Iceland's three largest banks in 2008 that caused the worst loss relative to GDP than in any other country. It is therefore less surprising the Iceland's prime minister found the political strength to commission a report on the possibility of moving Iceland to a narrow banking system, Sigurj?nsson (2015).

The report finds that to accommodate their lending activities, banks expanded the money supply nineteen fold between 1994 and 2008. The report argues that banks' lending activities tend to amplify the economic cycle (expansion during boom time and contraction during downturns). In addition, the government guarantee of bank deposits gives banks an unfair competitive advantage over other non-guaranteed financial institutions.

Huber and Robertson (2000) and Dyson et al. (2014) propose taking away banks' ability to create money and let central banks gain full control over the money supply. This will enhance stability reduce economic fluctuations. Another advantage would be that governments (not banks) will be able to collect the seigniorage revenue associated with money creation.

Recent attempts to eliminate fractional-reserve banking is currently taking place in the "land of banking:" Switzerland. In 2016 the Swiss government was supposed to hold a referendum on the Vollgeld Initiative that would require private banks to hold 100% reserves against their deposits.

Currently-operating narrow banks

England has one operating narrow bank which is designed for savings purposes. The National Savings and Investments (NS&I) is state-owned and is 100% safe as all savings are backed by the Treasury. The NS&I was established in 1861 by the national post office to encourage people to save (video). 

Norway also has one operating narrow bank called The Safe Deposit Bank of Norway.

The transition period

A complete switch to narrow banking would eliminate "money creation" by banks as banks will maintain 100% reserves mostly held in the central bank. This raises the question how money that has already been created by banks would be eliminated during the transition period.

Amazingly, the originators of the narrow banking proposal were aware of this potential problem. Fisher  (1936) explicitly addressed this issue by proposing that money created by banks would be turned into government loans to banks, until banks manage to collect all the money they loaned out.

A less ambitious transition period could start by providing incentives and benefits to new financial institutions that maintain 100% (such as payments service providers to be discussed below). The coexistence of 100% liquid banks with the traditional fractional-reserve banks would be possible if central banks pay sufficiently high interest on reserves (some of which could be passed on to depositors), see Tobin (1985).

The digital revolution

Financial technology (FinTech) is an emerging industry with startup companies that develop software for the purpose of disrupting the traditional banking sector. The book by McMillan (2014) predicts that the digital revolution will bring the banking era to an end.

The Bank for International Settlements analyzes the presence of non-banks in all stages of the payment process and across different payment instruments. These services are widely used by all sorts of consumers, including those who do not have bank accounts. Owners of general-purpose reloadable (GPR) prepaid cards who do not have checking accounts comprise 4.8% of U.S. adults.


Policy recommendations and FinTech

Source: Das (2017). The figure reveals how low-cost disruptive FinTech firms may gradually replace all the functions provided by traditional fractional-reserve banks.

 Is there any hope for a change?

Just like the failed attempts during 1930s, it seems unlikely that narrow banking will be implemented in the near future because of strong resistance from the financial sector, sharp disagreements among academic economists as to whether narrow banking is the cure, strong lobbying, and lack of motivation on the regulator side.

Is this the end? Not yet! Ongoing and emerging technologies (FinTech) are on the narrow banking side of this debate.

Some non-banks service providers are potentially "narrow" banks

Non-bank service providers such as PayPal, Venmo, Square Cash, Stripe, Dwolla, Walmart's Bluebird Card, Green Dot, Target's REDcard, and even Bitcoin, provide bank-like services at a lower cost consumers generally pay for similar bank-provided services. In fact, the linkage between technology change and narrow banking was already identified long before the term 'FinTech' existed, see Miller (1998).

Currently, non-banks that provide bank-like services are at a competitive disadvantage because they:

  1. Must obtain separate licenses and adhere to different regulations in each of the 50 states in the U.S.

  2. Must deposit unused balances with banks (and pay fees to fractional-reserve banks).

  3. Have no direct access to low-cost  settlement services provided by central banks, and therefore must  settle their transactions via the banks.

Policy options to promote efficiency

To overcome this obstacle and to encourage competition with established banks, it has been proposed that non-bank payment service providers would be allowed access to the same services that banks currently receive from central banks, see for example Bank of England (2015, pp.7?8). The United States OCC is now considering granting "Fintech charter" applications to become special purpose national banks. In fact, Ricks, Morgan, John Crawford, and Lev Menand (2018) propose giving the general public?individuals, businesses, and institutions?the option to hold accounts at the central bank.

Allowing non-banks to open accounts with central banks would remove a major obstacle faced by non-banks. Because the transactions performed via these service providers are prefunded, they actually behave as narrow banks that maintain 100% reserves and pose no risk on the system. In fact, in the early days of central banking, it was fairly commib to offer accounts not just to banks but also to non-banks, see Footnote 2 in BIS (2018).

The advantages of moving to such an industry structure include:

  • Risk reduction: All payments are prefunded and stored in central banks.

  • Newer technologies (real-time payments) at a fraction of the cost.

  • Gradual shift of depositors from fractional-reserve banks to institutions that maintain 100% reserves.

BIS (2018) reviews a proposal to have central banks issue central bank digital currency (CBDC) which would replace conventional currency and money creation by banks. In such economies, individuals and businesses would be able to open accounts and maintain balances directly with central banks.

But, what about the lending side?

A common criticism of the narrow banking proposal is that it neglects to reform the lending side of banks. The critics argue that narrow banking will push more lending activities into shadow banks that are also risky and less regulated.

However, this criticism neglects to consider the fact that  lending could be easily managed by mutual funds. As mentioned above, the mutual funds market in the U.S. has over 8,000 funds with total assets exceeding $15 trillion. Worldwide mutual fund assets now exceed $31 trillion. Funds such as those that diversify between stocks and bonds could add 10%?30% mortgages and other household loans into their portfolios. Investors and pension funds should be able to select the funds that match their risk versus return goals.

The advantages of shifting lending activities from fractional-reserve banks to mutual funds include:

  1. Lenders (investors) will be able to choose the degree of risk associated with lending activities. Currently, under fractional-reserve banking, banks bundle risk with deposit safe-keeping without asking depositors what degree of risk (if any) they prefer, Shy and Stenbacka (2000, 2008).

  2. Increase transparency. Mutual funds list their portfolios on the Internet. In contract, banks do not report what they do with depositors' money.

  3. Reduce or eliminate debt from the economy because loans become transfer of existing funds (as opposed to money creation by banks), Kotlikoff (2010).

  4. Eliminate  taxpayer responsibility from having to bailout banks when borrowers default on their loans.

Finally, note that FinTech is already active in the lending dimension as well. Companies such as LendingClub (now public), Prosper, Lend Academy, and CommonBond, facilitate peer-to-peer lending without having to create any new money.


Other distortions associated with the current financial system

(a) Expansion of the banking sector crowds-out real investment

"...we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity."  
James Tobin, 1981 Nobel Prize laureate, (1984, p.14).

Perhaps the real danger of the fractional-reserve system is that it can grow with no bounds. The table below (King, p.95) exhibits the alarming growth in the ratio of bank assets to annual GDP.

  U.S. U.K.
Change in 100 years 20% to 100% 50% to 500%
Top 10 banks today 60% 450%

By 2007, this ratio has reached 800% in Iceland. What fractional-reserve banks do is to increase their asset side with all kinds of financial instruments (CDO, MBS, CDS)  that have nothing to do with deposit taking. Moreover, bank holding companies are not prohibited until this very day from trading and owning commodious such as aluminum and crude oil, see Omarova (2013). Once these assets lose their value, it is hard to figure out what banks did with depositors' money, and governments use taxpayer money to recover the lost funds. With narrow banks, the size of the assets equals exactly the amount of deposits held by banks.

As noted in Kay (2015), since the 1960s, a larger fraction of college graduates in general, and engineering schools in particular, accepts jobs outside their field to become investment bankers or management consultants. Shy and Stenbacka (2017b) construct an overlapping-generations model to demonstrate how bank money creation diverts resources from productive activities. 

Apart from the crowding-out of human capital (misallocation of skilled labor), Cecchetti and Kharroubi (2012, 2015) show theoretically as well as empirically that financial sector growth disproportionally benefits sectors with low productivity and high collaterals, thereby reducing total factor productivity growth in the economy as shown in the following graph:

The graph shows that per-worker GDP growth can decline with an increase  in a country's share of employment in the financial sector (deviation above the country's mean). Similar inverted U-shaped results are also estimated in Arcand, Berkes, and Panizza (2015), where the financial sector has negative effects on growth when the credit to the private sector reaches 80-100% of GDP.

The following graph, taken from an IMF study, Barajas et al. (2015), estimates that if the financial sector were the proper size, the U.S. economy would be enjoying a normal economic recovery of 3% to 4% per year instead of the dismal 1% to 2%.


Epstein and Montecino (2016) measure the excess social cost of large financial sectors by adding three components: (a) rents, or excess profits; (b) misallocation costs, or the price of diverting resources away from real investments; and (c) crisis costs, meaning the cost of the 2008 financial crisis. They estimate that the financial system will impose an excess cost of as much as $22.7 trillion between 1990 and 2023, making finance in its current form a net drag on the American economy.

(b) Government loss of seigniorage revenue

Taxpayers incur an additional loss of revenue from letting commercial banks create money (see above) instead of the government or the central banks. The profit generated from the creation of money is called seigniorage, which is defined as the difference between the cost of physically producing money and its purchasing power in the economy. For example, if a $10 note costs 20 cents to produce, seigniorage profit to the issuer of this note is $9.80. A 2017 report and Bjerg et al. (2017) computed the seigniorage taxpayer loss of revenue at the aggregate national level of selected countries to be:

That is, British taxpayers lose 1.23% of their GDP to commercial banks. The narrow banking proposal provides an immediate solution to this revenue loss by leaving money creation to the central banks and by requiring banks to maintain 100% reserves.

(c) Bank money creation amplifies the business cycle

Several papers, going back to Simons (1936), observed that banks' money creation via lending activities amplifies the economic business cycle to the benefit of commercial banks. More precisely, during boom time banks create "cheap" money and extend loans to individuals and businesses that may not be able to pay back when the value of their assets drops below the remaining value of loans (underwatered). During downturns, banks radically contract their lending activities thereby exacerbating the downturn and creating a total collapse of the economy. 


Entertainment and fractional-reserve banks

"Mary Poppins" banks

There may be no better place to learn about the structural weakness of the current banking system than from watching the 1964 Disney classic movie entitled Mary Poppins. Dick Van Dyke, portraying a chairman of a bank who is a "giant in the world of finance," tries to convince the kids to hand him their tuppence for the purpose of opening a bank account. He sings:

If you invest your tuppence
Wisely in the bank
Safe and sound
Soon that tuppence,
Safely invested in the bank,
Will compound

And you'll achieve that sense of conquest
As your affluence expands
In the hands of the directors
Who invest as propriety demands


You see, Michael, you'll be part of
Railways through Africa
Dams across the Nile
Fleets of ocean greyhounds
Majestic, self-amortizing canals
Plantations of ripening tea

(Watch the song and bank run scenes on You Tube)

The old chairman ends his lecture by stating that "where stands the bank of England, England stands, and when falls the bank of England, England falls!" Eventually, the kids refuse to deposit their tuppence and create a panic leading to a run on the bank, so the kids' expectations become self-fulfilling.

The Long Johns

In 8 minutes you will learn about everything you felt ashamed to admit that you don't understand. Terms like: Subprime market, investment vehicles, structured high-grade funds, and investment banking. and how the financial sector obtains money from the government during banking crises.


Jon Stewart  on bailing out banks using the Federal Reserve's and  taxpayer money: Federal Reserve's subsidy, banks' non-accountability, JP Morgan's losses, Congress is afraid of Jamie.  

Ry Cooder sings: "No banker left behind."


Literature on narrow banking and full-reserve banks


Other proposals for how to reform the banking industry and FinTech


Literature on misconduct, political power, lobbying, and fragility of the banking industry


Literature on taxpayer and central bank subsidy of banks


Literature on the crowding-out effects of large financial sectors and bank money creation


Links to Internet sites with suggestions how to reform the banking industry

General Information

The purpose of this site is to stimulate discussions and research on how to reform the banking system
This site first went live on June 11, 2015 (Last update, October 30, 2018)
The URL directed to this site is: www.NarrowBanking.org