A Guide to Banking Reform and Narrow Banking

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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 banking proposal calls for a total separation of bank deposit accounts from banks' lending 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, 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 $67.8 billion, resulting in a reserve ratio of 1.06% out of total deposits. This means that the FDIC fund can recover only 1% 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. Sigurjónsson (2015) argues that Iceland faces a similar situation for any of its three- largest banks.

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).

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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 13th-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 global financial collapse.


In 1361 Venice's Senate prohibited lending out depositors' money (thereby creating narrow banks!).

Over time, laws were repealed and in 1584, Venice's largest bank House of Pisano & Tiepolo closed because of inability to refund depositors. The bank is made into a state banks, and then failed in 1619


In 1790, the Bank of Amsterdam was taken over by the city. 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 fail. The government of Sweden guaranteed all bank deposits of the nation's 114 banks and assumed some of bad debts.

 

 


 

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

Graph on left shows increased debt due to extension of credit (loans).

 

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 illustrates the number of U.S. banks that failed since 1865.

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).


 

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

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

Boyd et al. (2014) provide extensive list of bank failures in different countries. British bank failure wave includes

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Taxpayer subsidies provided to banks and social costs

The big puzzle

If,

  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 33 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 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 why 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 risk 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.

The direct taxpayer cost of the most recent 2008 crisis exceeded $700 billion. 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 was forced to release it after Bloomberg sued.

The following graph, taken from 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.

Social costs of banking crises

Before we proceed to analyze the amount of taxpayer subsidies provided to the banking sector, note that implicit and explicit subsidies of banks constitute a small fraction of the social cost of a financial crisis. n a cross-country analysis,

Hoggarth et al. (2002) estimate the cost of banking crisis 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).

 

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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: The graph below (source) reveals that banks spend over $1 million a week on lobbying activities. 


 

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 later repealed by Congress itself after banks intensify their lobbying activities.

2. Regulatory capture: Regulatory agencies have no incentives to enforce the regulations. In fact, 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 Fed managed to overstep the U.S. constitution by giving trillions of dollars in loans to financial institutions. Their book argues that the 1913 Act managed to make the Fed totally independent political pressure. However, instead it made the Fed totally dependent on the financial sector that it is supposed to regulate. The drawback of this dependence is not only favoritism to financial institutions and revolving doors, but the total immunity from the check-and-balances democratic system and transparency.

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

The failure of Basel I, II, & III ( Basel Committee on Banking Supervision)

This widely publicized international committee suggests regulatory guidelines on the minimum amount of capital banks should hold. Currently, the committee recommends a minimum Tier 1 capital ratio of 6%. To get an idea why 6% does not protect banks against failures, compare 6% with Admati and Hellwig (2014) who argue that banks should be at least 30% equity financed. 

The Glass-Steagall Act of 1932–1935

Following 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 would then be prevented from dealing with non-governmental 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 cases, and by regulatory agencies that issues weaker interpretations of the requirements intended to separate investment banking from deposit-taking banks. Finally, in 1999, 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 rolls back a rule that restricts trade in derivatives, the 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 failing banks.

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

Here is the story: On November 9, 2015, the Financial Stability Board (FSB) issued new guidelines on bank balance-sheets that require banks to increase their capital ratio to 16% by 2019 and to 18% by 2022.

Capital ratio consists of mostly debt (yes, banks borrow a lot) plus equity (value to shareholders) 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 will 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 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. 

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History of the narrow banking proposal

The proposal for depository institutions that maintain 100% reserves goes back to the Great Depression and is attributed to a group economists at the University of Chicago in response to the Great Depression. In 1933 the 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. This 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 reducing or terminating 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 calls 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 correctly 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 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 have finally possess  the political power to refuse to bailout financial institutions because deposits' money will be 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.

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History of fractional-reserve banking

Definition of "fractional reserve"

Commercial banks operating today 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 will not able to meet the demand for cash withdrawals unless the withdrawals are made by a small fraction of account holders.

From Middle Ages Europe and the Renaissance to the United States

Fractional-reserve banking emerged in Europe during the Middle Ages from 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.

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 the 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, 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.

Unlimited expansion of the banking sector

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. 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 deposits held by banks.

Has anything changed since the Middle Ages?

Not really, since the Middle Ages banks continue 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 reduces 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.

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Past and ongoing attempts to implement narrow banking

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, Sigurjónsson (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.

In the same vein, McLeay et al. (2014) dismiss the textbook explanation of banks as intermediaries between lenders and borrowers. Using banks' balance sheets, they prove that new loans should counted as new money rather than as a transfer from savers to borrowers.

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.

The most recent attempt to eliminate fractional-reserve banking is currently taking place in the ``land of banking:" Switzerland. In 2016 the Swiss government will hold a referendum on the Vollgeld Initiative that would require private banks to hold 100% reserves against their deposits.

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 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 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. For example,  owners of general-purpose reloadable (GPR) prepaid cards who do not have checking accounts comprise 4.8% of U.S. adults.

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FinTech and Policy options

 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, and lack of motivation from 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).

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.

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.

But, what about the credit side?

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

Clearly, the lending side should also be secured against large defaults. In that sense, moving to narrow banking should be viewed as a first step of a comprehensive banking reform. This first stage is crucial for the following three reasons:

  1. Securing depositors' accounts will significantly enhance governments' political strength to refuse to bail out failing banks.

  2. The reform would start where banks are needed the most: Account safekeeping and payment services.

  3. Implementation in stages may invite less resistance from the financial sector.

As for a lending reform, there are several  proposals for how to reform the entire financial system including the credit side: Large equity financing (Admati and Hellwig), lending via mutual funds (Kotlikoff), and systemic solvency (McMillan). These proposals are not mutually exclusive and may vary across the type of the lending institution. 

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.

 

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A logical problem with the theory of money creation

The textbook theory of money creation

Most college textbooks on money and banking describe a model showing how banks create money. The reader should bear in mind that even if the model were true, there has not been any research that provided any social welfare justification for money creation by commercial banks.

 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, the banking system has created additional $900 of inside money from an initial $100 deposit.

A  logical problem with the standard explanation

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

The answer is that the person has probably received the $100 from her employer. But the employer had to get the $100 from somewhere, which means that the employer withdrew $100 from the business account. Therefore, the total net change in the money supply should be zero and not $100.

The main conclusion of that paper is that, contrary to the standard textbook assertion that "deposits create loans," the revised 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 banks' pens when they approve loans. The former governor of the Bank of England King (2016) calls this process money "alchemy" (creating money from thin air).

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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.

Others

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."

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Literature on narrow banking and full-reserve banks

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Other proposals for how to reform the banking industry

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Literature on the fragility of the banking industry and its consequences

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Literature on taxpayer and central bank subsidy of banks

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


Contact Information

Comments and suggestions should be sent to: info@narrowbanking.org
The purpose of this site is to stimulate discussions and research on how to reform the banking system
The site is currently maintained by Oz Shy. This site first went live on June 11, 2015 (Last update, June 8, 2016)
The URLs directed to this site are: www.BankingReform.org and www.NarrowBanking.org

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