Narrow Banking Can Actually Be the Solution

Martin Wolf has an article entitled Why narrow banking alone is not the finance solution. He writes that one of the solutions proposed by John Kay in a pamphlet for the London-based Centre for the Study of Financial Innovation to the banking crisis is to create “utility” banks and “casino” banks. Regulate the “utility” bank, Kay says, and let the “casino” bank take risks.

Wolf then goes on to criticize this approach:

A more profound issue is whether a financial system based on narrow banking could allocate capital efficiently.

Here there are two opposing risks. The first is that the supply of funds to riskier, long-term activities would be greatly reduced if we did adopt narrow banking. Against this, one might argue that, with public sector debt used to back the liabilities of narrow banks, investors would be forced to find other such assets.

The opposite (and greater) risk is that the fragility of banking would be re-invented, via “quasi-banks”. This is what has just happened, after all, with “shadow banking”. In the end, those entities, too, have been rescued. The big point is that a financial structure characterised by short-term and relatively risk-free liabilities and longer-term and riskier assets is highly profitable, until it collapses, as it is rather likely to do.

The answer to the second dilemma is to make banking illegal. That is to say, financial intermediaries, other than narrow banks, would have the value of their liabilities dependent on the value of their assets. Where assets could not be valued, there would be matching lock-up periods for liabilities. The great game of short-term borrowing, used to purchase longer-term and risky assets, on wafer-thin equity, would be ruled out. The equity risk would be borne by the funds’ investors. Trading entities would exist. But they would need equity funding.

A better solution
Martin Wolf has written many cogent and insightful analysis of finance over the years. This is one of the rare cases where I disagree with him. The problem isn’t one of defining a regulatory framework for a “casino” bank, but that the incentives for the management of the “casino” bank are asymmetric and misaligned.

Instead of building a convoluted regulatory environment for banking, just bring back the partnership investment bank.

Allow market forces to work. If the partners at the "casino" bank want to pursue short-term returns at the cost of excessive long-term event risk, let them. The ones with adult supervision will survive, the ones without will blow their brains out and their failure will serve as an example to others.

Comments

[derryl:]

I agree. Let market forces work. Which means if casino bankers lose, THEY lose, not taxpayers. And since they can only bet the equity they have managed to acquire, there will be no megaleveraged house of cards bringing down the financial system.

Narrow banks really are "utilities". They are a consumer good or a consumer service. Consumer goods have to be "idiot proofed" before regulators will allow them on the market. If even one idiot hurts himself because of some 'danger' in a product, the regulators force a recall and the producer has to redesign his idiot proofing.

Narrow banks should be like that. Consumers are not financially sophisticated. They need the protection of narrow idiot proofed financial products.

Oct 02 08:59 PM

[warriornasdaq:]

Cam you said to buy Imperial Capital Bank at $4.86 last October 2008 here it is a year later its .36 cents, you can now buy IMPC like your buddy Tom Micklas my hero said buy at $10, both of you need to back up the truck and load it with IMPC and back up your articles.
Put your money where your mouth is and buy IMPC off the lows. When you gonna buy it when it gets back to $5?? Cut the BS Cam and buy IMPC and post in your next article you loaded up at the lows. If you believe what you say then you like the bank survivors like Imperial Capital Bank, ive already bought a ton of shares i suggest you do the same your pick is down -99% save face and buy it back at the lows eom

Oct 03 02:10 AM

[Cam Hui:]

Warriornasdaq:

I did not "tell" anyone to buy anything. If you re-read that post of October 26 I highlighted some values but also expressed my reservations: humblestudentofthemark...


However, my inner top-down investor remains concerned that there is too much macro downside risk. The market is too dependent on policy response for me to sound the all-clear for the bulls.

Disclaimer: I don’t have a position in any of these stocks. You should not consider this as a recommendation to trade any of them. You are responsible for your own portfolio and you should do your own homework.

Oct 03 06:31 PM

[warriornasdaq:]

Cam i'll cut you a break on this one, you get a pass and i apolagize, but you still essentially picked those stocks at those prices and said there was a lot of value in those banks, then you added some disclaimers to cover your butt, you cant have it both ways. i could careless i'm buying imperial at the lows they're a survivor eom

Oct 04 12:06 AM

[warriornasdaq:]

Cam u missed IMPC up a whopping 41% Imperial hired a new CEO, IMPC should rip further north back over $1 wallst will give the new guy a chance to turn things around, ya do your home work Cam now back the truck up we could see 1000-10000% on IMPC gain back to book value $19.50 eom

Oct 05 11:52 PM