The American Banking System Should Be Modernized, But Narrow Banking Is Not The Right Way

by: Martin Lowy


Recent articles on S.A. and in the FT, as well as a Swiss referendum, have again put forward narrow banking proposals as modernizations.

I fear the greater power such proposals would give to central banks, as well as the radical way they would change the flow of credit.

Our current system has many defects--in safety, in the ways it fails to serve less affluent people, and in the ways that it places obstacles in the way of innovations.

Those defects should be cured, and this article outlines the steps to take to cure those defects.

Lawrence Kotlikoff published a useful article at S.A. on June 6, in which he advocated a form of narrow banking—his version being basically “all-equity” banking. On the same day, Martin Wolf, Chief Economic Correspondent for the FT, published an article advocating that the Swiss should vote in favor of the concept of “Vollgeld”, a similar sort of narrow bank proposal that was designed to place the money supply more firmly within the control of the central bank, but that Swiss voters rejected on Sunday.

Kotlikoff’s proposal mostly was motivated by banking safety. The Vollgeld proposal was mostly motivated by the desire to end “fractional reserve banking”, which effectively permits commercial banks to create money by crediting demand accounts with when they make loans. But the two kinds of proposals would have much the same consequences.

I have been exploring narrow banking ideas ever since Bob Litan published his book What Should Banks Do? in 1982. From time to time I have been ready to embrace some such proposal, but, as reflected in my S.A. review of Morgan Ricks’s excellent book The Money Problem, that advocated its own well-thought-out narrow banking proposal, I do not quite get there because I believe there are less radical solutions to the very real problems that Ricks, Kotlikoff, Wolf and many others have identified. (You might also want to look at the recent writing on the subject by Ralph Musgrave and John Cochrane.) Ricks provides the best explanations of the problems. My review of Ricks’s book attempts to summarize his most important insights.

But narrow banking, while probably solving one set of problems, probably causes a different set of problems, and it pays no attention to the need for more universal access to mainstream financial services, which I think should be central to any significant revision of the current system.

Narrow banking would not, in my view, be good for the economy or, therefore for investors because it would give the Fed more power than its performance suggests it deserves, and it would change the credit mechanism in ways that might increase cost or decrease availability. These points are explained below.

But investors should want to change the current system to make it safer because the biggest investment losses occur in financial panics. Though Dodd-Frank did improve safety, it did not go far enough.

Would central bank technocrats manage the economy better if they had less interference from the market?

One problem with narrow banking is that it (intentionally, by the way) gives even more power to the central bank than it has now. The advocates of narrow banking in its various forms contend that it will make monetary policy easier to conduct because it will make the money supply more knowable—that is, commercial banks no longer will be able to create money or money-like instruments. The money supply, it is suggested, is too important to be left to a select group of private parties that we call banks. In effect, it is alleged, pure ratiocination by central bankers will produce better results because the central bankers will be able to affect the money supply directly and without private party interference.

Hmm, I wonder . . . Would it be so good to allow central bankers to have so much power? Do the technocrats really know what they are doing so precisely that we should leave it all to them? I really do wonder, especially since managing monetary policy often has seemed to me rather like alchemy.

Admittedly, I am not trained in macroeconomics, but I have been studying the subject gradually for about 40 years, and despite all my efforts, I still frequently get the feeling that the Fed is making it up as it goes along. Some of John Cochrane’s recent posts on his blog have encouraged me to continue that line of thinking.

Money seems to be a very slippery concept. It keeps changing, and in response, the Fed keeps changing the way it tries to affect the economy. It all makes me wonder whether central bankers really should be given even more power over monetary policy. More power, it seems to me, would magnify mistakes because mistakes would be harder for the market to counteract.

It is true that, even in the current state of monetary policy responsibility, the Fed is asked to do central planning, almost as if we did not have a market economy. That is, to some extent, inevitable, given that money is a creation of the state. But I would be reluctant to place my faith in less power for the markets and more power for the technocrats, even though maybe the technocrats would understand money better if it were simplified.

Should the credit-granting function be fundamentally changed?

I also wonder whether changing the fundamental way that credit is granted is a good thing. Maybe it would be. But despite its defects, the current basic system has worked to provide capital to a growing economy for many years. Banks are unstable—yes—but perhaps we can deal with instability that without narrow banking. See my 2017 book InStAbILItY for a more extended discussion.

Therefore I have formulated a set of proposals that stop short of narrow banking. They focus on four objectives: (1) making banks less fragile, (2) encouraging natively digital banking solutions to compete with (and presumably outperform) existing legacy systems, (3) providing more universal access to mainstream financial services, and (4) using consumer protection to enhance the other three goals. At the same time, in formulating these proposals, I have tried to adhere to the maxim, “First, do no harm.”

Marty’s Proposals to Make the System Safer and More Responsive

The reason we have to think about major changes is that our financial system looks just about perfect only if you forget that it is clumsy, dangerous, and fails to serve a substantial fraction of the population. Ideally, the 21 st century information age would bring greater clarity, safety, universal access, and lower cost. Therefore we have to think about whether a few moderately radical changes would help to usher in the new era of safety and digital access without doing violence to the principles that seem to have served us well.

The goals of the proposed changes are:

  • Reduce the probability of bank or bank-like runs—and thus, the worst aspects of financial crises. That is a principal purpose of most narrow banking proposals, but I do not think we have to go that far to achieve the objective. I have stated my reasons on a number of occasions, including in the review of Morgan Ricks’s book cited above.
  • Provide better financial services to the average consumer, including less affluent consumers. This has not been a major goal of U.S. banking policy over the 50 years that I have been involved in it. But that should change because digital banking need not be as expensive as its paper-based equivalent has been, and therefore the cost barrier should become surmountable. Lack of access to the mainstream financial system has imposed costs on the class of Americans who least can afford them. Permit more entities to compete in financial services, thereby reducing dependence on banks.
  • Competition is the best way to reduce cost, and reducing cost is the best way to reduce price. The impediment always has been the basis of the system on deposits—and therefore the safety of deposits, which has required getting a banking license in order to compete. The new system should permit service providers to build delivery systems without having to worry about where the deposits are held.
  • That leads naturally to universal free electronic deposits at the Federal Reserve Banks.
  • Preserve the benefits of the U.S. capital markets that fund American businesses.
  • Inhibit the build-up of excess credit to people or enterprises that cannot be expected to be able repay through the cycle.
  • Consumer protection, combined with strict stress-tested capital adequacy requirements are the best way to inhibit the granting of credit to those who cannot repay.
  • At the same time, enhanced means to gain access to equity capital should be encouraged, since equity capital does not have to be repaid.

Consumer accounts at Federal Reserve Banks

The central feature of my proposal is to permit anyone with a social security number to have an account at a Federal Reserve Bank that is accessible only by electronic means. There are three basic reasons for this:

(1) An account at the Fed is safe per se, and therefore it would not be runnable.

(2) By permitting private companies to offer services to consumers through their accounts at the Fed, consumers of all types could be provided electronic banking and related lifestyle services without the service providers having to think about getting a banking license—they would just have to meet the Fed’s reliability criteria, which might be strict, but which would not amount to imposition of bank-like rules.

(3) The Fed could offer what effectively would be government-guaranteed certificates of deposit at rates equal to the rates on government securities (less a few basis points for expenses) at any maturity that a depositor might want. The Fed currently offers reverse repos to institutions. This aspect of the individual accounts would be merely an expansion of that program.

As John Cochrane opined in a May 29 blogpost,” There is no reason for government debt to be artificially illiquid by maturity or denomination. Governments could offer reserve-like debt to all of us, essentially money market accounts. Too bad for contrary hallowed doctrines.”

What would happen to existing banks if the Fed did offer electronic-access-only deposit accounts to consumers?

Impact on FDIC-insured banks

In order to make all bank accounts non-runnable, all bank accounts, at all banks regardless of size, would be guaranteed by the FDIC. That would make any Fed advantage over banks quite minor—and because the Fed has no branches, would offer no paper checks, and would make no loans to individual consumers, relatively few more affluent consumers would give up their checking accounts at banks in favor of an account at the Fed.

The proposal also contemplates, however, some additional restrictions and benefits to make banks safer:

  • All FDIC-insured banks and their holding companies would be required to maintain stress-tested capital of at least 12% of total liabilities, plus an additional 4% of all liabilities deemed to be runnable.
  • Any bank that complied with all capital requirements at its last stress test would be eligible for liquidity assistance from the Fed without any current solvency test. Thus no FDIC-insured bank would be runnable, regardless of the public’s perception of its financial strength or weakness.
  • Proprietary trading and market making activities of FHCs (financial holding companies that include FDIC-insured subsidiaries) and their non-FDIC-insured subsidiaries would be permitted. But such investments would be limited to 50% of the stress-tested equity capital of the FHC. This would eliminate the need for the Volcker Rule but would require that, in effect, all proprietary trading and market making be conducted with equity. If a bank wanted to conduct trading activities with borrowed money, it would have to adopt a different corporate structure that did not include an FDIC-insured bank. See alternative forms below.
  • No derivatives trading would be permitted in an FDIC-insured bank itself—only in non-bank subsidiaries of the FHC.
  • To avoid a regulatory competition in laxity, only the FDIC could charter a bank. (Competitive innovations would be expected to come from opening the competitive faucet to non-banks through the use of deposit accounts at the Fed, as described above, as well as through FDIC-insured banks adopting the best available technologies.)
  • All banks and FHCs would be required to make their general ledgers accessible electronically by qualified Fed personnel. Traditional on-site examination and similar supervisory tools could be eliminated because the Fed could monitor banks’ portfolios and balance sheets in real time, using technology to discern exceptions to declared bank policies. Such exceptions then could lead to dialogue between the bank and the Fed, with the possibility of supervisory action if the dialogue were not resolved to the satisfaction of the Fed.

Thus the prudential safety and soundness aspect of bank supervision would be at the same time strengthened and simplified, so banks would be freer to provide credit to the market as they saw fit, within the parameters of maintaining capital strength. This is potentially a big advantage compared with narrow banking, in that insured deposits still could be used to make loans, thus potentially reducing the cost of credit, against what its cost would be if lenders were permitted to use only equity capital, as would be the case in most narrow bank regimes.

Regulation of non-bank financial entities

Not all entities that now are deemed to be banks or FHCs might want to continue those designations under the new rules. They might prefer a new form, and the new regime would permit them to opt out of the insured bank paradigm in favor of a structure that was relatively free of federal bank-type supervision.

Thus, what is now a bank could elect to become not a bank simply by electing not to accept deposits. It would, however, continue to be bound by the rule not to have runnable liabilities in excess of 20% of its total capital and liabilities, which would apply to all entities other than individuals, and would be required to match runnable liabilities with similar amounts of short-term assets. Such an entity would not be regulated as a bank, and its owners would not be regulated as bank holding companies. But they would be regulated regarding the match between runnable liabilities and liquid assets.

If an entity related to such non-bank, non-FHC were a broker-dealer, the entity would be regulated under broker-dealer rules as well as the 20% rule regarding runnable liabilities. In addition, such an entity also would not have an exemption from the Investment Company Act, which exemption would apply only to the registered broker-dealer subsidiary. The elimination of this exemption would be in recognition that most of the large broker-dealers that have failed in the last 40 years have failed because their parents and affiliates have engaged in proprietary investments, not because of their broker-dealer operations. See my discussion of the data in InStAbILItY.

These requirements regarding non-runnability of liabilities are designed to provide the benefits of narrow banking without adopting narrow banking itself. One could argue that greater percentages of runnable liabilities should be permitted, but the concept is iessential, as Morgan Ricks has explained better than anyone else. (Larry Kotlikoff’s formulation includes this kind of concept as well, because analysts now recognize that runnable liabilities are at the heart of runs on financial companies, regardless of whether they are banking companies.)

Consumer protection

We now come to one more critical set of rules that must be changed. That is the rules that protect consumers entering into financial transactions.

No one who believes in market capitalism could have studied the GFC without concluding that consumers needed far better protection from over-reaching financial providers—both large institutions and local agents who preyed on their neighbors. Capitalism simply does not work if consumers are fooled or even defrauded. That is because capitalism depends on the aggregate of the market (mostly people) to allocate resources efficiently. If the people who make up the market are given false information about what they are buying, then they will allocate resources inefficiently.

The CFPB (Consumer Financial Protection Board) created by Dodd-Frank in 2010, was supposed to be the agency that accomplished what I seek to accomplish under this heading. Unfortunately, the CFPB was organized in a peculiar way, it became identified with Senator Elizabeth Warren, a polarizing consumer advocate, and Richard Cordray, its first Director, was imbued with crusading spirit and a penchant for regulating by litigation. Those factors led to even more opposition from right-leaning business groups and economists than naturally needed to be the case.

To curb the CFPB, President Trump appointed Mick Mulvaney as Director, basically to undo the work of Mr. Cordray and to repeal much of the agency’s best work, as well as its worst. The result has been such a mess that it would be preferable to start over with a new, more traditionally organized, independent agency.

The new consumer protection agency would be called the Consumer Finance Fairness Commission (the CFFC) and would be organized with a three-commissioner structure similar to the FDIC. Its jurisdiction would be to supervise all consumer credit and all products sold in connection with consumer credit, regardless of the source of such products or services. However, the Fed would supervise all products dealing with the payments system and deposit accounts.

This new agency (the CFFC) would have the stated goals of ensuring that credit was offered fairly and without discrimination but only to customers who could demonstrate a likelihood that they could repay in accordance with the terms of the credit.

The CFFC would be encouraged to offer safe harbors to credit-granting entities but also to strictly enforce such safe harbors as well as other credit-related laws and regulations.

The CFFC also would set all rules for credit accounts and their interest rates and other charges, preempting all state laws and giving banks no more favorable treatment than other credit-granting entities. This would end the states’ race to the bottom and the loophole-related federal charters that financial service providers use to circumvent state regulation.

The standard excuse for state regulation has been to enable experimentation and innovation by permitting competition between the states. That has been the mantra for more than 50 years, and as counsel to state banking associations and state regulators, I mouthed it in the 1970s, 1980s and 1990s. But the reality is that innovation in financial services has been held back, not enhanced, by the multiplicity of state rules. Many of the state rules have had exemptions for banks, for example, which has made it nearly impossible for non-banks to compete on a level playing field. And the multiplicity of state rules has made size a prerequisite for competing in many financial products and services because compliance costs have been so great. The time has come to grasp the nettle and institute uniform federal rules. Yes, some of those rules will be more restrictive than they should be. But it would be better to fight those kinds of rules in the political arena rather than to favor companies with bank charters and, particularly, large ones.


To summarize:

Narrow banking addresses some real problems with the current system.

There are less radical ways to deal with those problems, however, and narrow banking would lead to new problems, including more dominance of the economy by unelected technocrats.

The less radical ways to deal with the problems should encourage universal access to the financial system, including access for less affluent Americans. The new system also should encourage increased competition from entrepreneurial service providers, and should replace the CFPB with an independent agency tasked with insuring fairness to consumers of financial products.

Individual electronic-access-only accounts at the Fed for any person with a social security number would be at the heart the new strategy because it would be easy to implement and would accomplish fairly universal access without burdening existing banks with costs to carry customers they do not want. The Fed accounts would have no overdrafts—and therefore no overdraft fees. Electronic payments are virtually costless. ATM access would have only whatever costs were imposed by the ATM owner. The Fed would have no ATMs. And, yes, except for older people, the vast majority of less affluent Americans do have smart phones or other access to the Internet through which they could engage in electronic banking.

Investors should care particularly about bringing mainstream financial services to less affluent consumers because doing so will expand the universe of customers for all kinds of goods and services. In addition, competition always is good for investors in general because it increases efficiency and expands the universe of productive investments.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.