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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.

Source: Narrow Banking Can Actually Be the Solution