Currently, banks are required to keep only a small fraction of their deposits as “reserves” with the central government bank, the Federal Reserve. Banks are free (though subject to voluminous regulations) to loan out and otherwise invest the rest of their deposits. Hence, the system is known as fractional reserve banking. (The regulations are there to prevent banks from taking excessive risks with depositors’ money, which sometimes works, sometimes doesn’t, but more on that below.) Narrow banks, in contrast, would keep all deposits at the Federal Reserve or invested in short-term U.S. Treasury bills.
Unstable and hazardous / Banks are said to be in the inherently unstable situation of borrowing short (from depositors, who can withdraw their money at any time) and lending long (to borrowers for mortgages, auto loans, business loans, etc., who pay back the loans over long periods). The inherent instability of this system is on display whenever there is a bank run, or a series of bank runs (also known as a banking crisis or the medical-sounding “systemic contagion”), or even in the perennial Christmas movie It’s A Wonderful Life, in which a bank run plays a supporting role.
To reassure depositors and prevent bank runs, the federal government insures bank deposits up to some specified maximum per account. But that still leaves us with at least three problems:
First, deposit insurance encourages banks to take excessive risks with depositors’ money because bailouts will happen if too many loans turn sour. Heads the bank wins, tails the federal government bails out depositors. That’s where the term “moral hazard” comes in. Economists use the term to describe what happens when you have more insurance than you ought to have, given how insurance can affect your attitude toward risk-taking.
Second, many depositors have balances at banks far greater than the insured maximum. Why would that be? In part, because of the next problem.
Third, the federal government sometimes insures bank deposits beyond the specified maximum, depending on such circumstances as the size of the bank (i.e., whether it is “too big to fail”), the risk of follow-on bank runs (systemic contagion again), whether uninsured depositors are too politically connected to fail, and the whims of officials in charge. What are the limits of deposit insurance? At this point, nobody knows. But the implicit guarantee of virtually all bank deposits, at least for the time being, has become a massive potential liability and an encouragement to reckless behavior.
With fractional reserves and uncertain amounts of deposit insurance, instability and moral hazard ensue.
Narrowness solves the problem / The collapse of the U.S. banking system in the 1930s led some economists to make the case for narrow banking, a system that requires banks to hold 100 percent of their deposits on reserve. All deposits are thereby 100 percent guaranteed, without risk to the federal budget. There would be no bank runs and no need to regulate what banks do with depositors’ money, beyond the 100 percent reserve requirement.
Some operational details: Banks, as banks, would provide only checking and saving services. As noted, banks could keep deposits at the Federal Reserve, which would pay banks the short-term Treasury bill rate as interest. Alternatively, they could hold short-term Treasury bills directly. And they could offer longer-term certificates of deposit backed by Treasury debt of the same duration. Competition would induce banks to pass the interest along to depositors, minus the cost of doing business.
Banks and other businesses could still make loans, as they do now, but that capital would be raised not from depositors, but from investors willing to bear the uninsured risks. Because banks currently provide a substantial portion of private sector debt, the transition to narrow banking would have to be gradual, over the course of a few years.
The academic interest in narrow banking is correlated with bank failures, but narrow banking is no fringe idea. It has a strong academic foundation, having been considered and endorsed by many prominent economists. One of the most coherent descriptions in support of narrow banking can be found—no surprise here—in Milton Friedman’s 1959 book A Program for Monetary Stability.
New developments / By the way, the Federal Reserve began paying interest on reserves in 2008 (to soak up some of the vast increases in the money supply). Banks currently hold about one-fifth of their deposits on reserve or as Treasury bills. We are already one-fifth of the way to narrow banking!
Given the interest currently paid on reserves, as well as the ability of banks to invest deposits in Treasury bills, some might ask: why doesn’t narrow banking arise on its own merits, without requirement? The reasons are straightforward. First, the payment of interest on reserves is an ad hoc policy that could be rescinded at any time. More importantly, deposit insurance is a massive subsidy. Under the current system, banks get very cheap insurance on a substantial share of deposits (and on all deposits if the bank is deemed too big to fail), and the banks get to loan out the money at rates higher than Treasury bills. Subsidized firms crowd out non-subsidized firms.
Another factor to consider is technology. People can transfer money via their laptops, cell phones, and other electronic devices. The recent run on Silicon Valley Bank was called the first “Twitter-fueled” bank run because of the app’s role in spreading news about the bank’s precarious status. Bad news travels faster than ever. All this technology may make banks more fragile, not less.
Given increasing instability and moral hazard, we are told, banks will have to be even more regulated. That’s always been the preferred solution. Volume 12 of the Code of Federal Regulations, which deals exclusively with “Banks and Banking,” runs to more than 9,000 pages, the equivalent of about eight Bibles (Old and New Testament).
Politicians and regulators claim to know what is needed: just a little more fine-tuning, a few thousand more pages of regulations, and the system will be, well, probably not much different than it is today, including the moral hazard and the arbitrary and uncertain federal guarantee of bank deposits. And, as banks become even more regulated, they will become even more subject to political pressure and manipulation. For instance, banks have increasingly been “advised” to not provide services to politically disfavored businesses. That’s not a recipe for stability, soundness, and the efficient allocation of capital.
Is now the time? / Would narrow banking eliminate the tendency of the federal government to bail out institutions that should not be bailed out? Of course not, but it would take banks out of the bail-out-and-regulate sector. Would banks still fail? Some would, but because they were out-competed in the provision of services to customers, not because of risky loan portfolios and bank runs. In the narrow bank sector, inherent instability, moral hazard, and uninsured deposits would all be relegated to the dustbin of history.
Unfortunately, the idea of narrow banking has always been a non-starter for political reasons; banks derive much profit from the current arrangement. Nonetheless, with regulatory overload and expanding deposit insurance, we may be at an inflection point. Banks may finally see a benefit in splitting their deposit-taking business from their loan-making business. Perhaps now is the time to take a broader view of narrow banking.
