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Fed Nixes Narrow Bank

Sep. 06, 2018 7:40 AM ET2 Comments
John Cochrane profile picture
John Cochrane

A narrow bank would be a great thing. A narrow bank takes deposits, and invests 100% of the money in interest-paying reserves at the Fed. (The Fed, in turn, mostly invests in US treasuries and agency securities.)

A narrow bank cannot fail*. It cannot lose money on its assets. A narrow bank cannot suffer a run. If people want their money back, they can all have it, instantly. A narrow bank needs essentially no asset risk regulation, stress tests, or anything else.

A narrow bank fills an important niche. Individuals can have federally insured bank accounts which are (mostly) safe. But large businesses need to handle cash way above the limits of deposit insurance. For that reason, they invest in repurchase agreements, short-term commercial paper, and all the other forms of short-term debt that blew up in the 2008 financial crisis. These are safer than bank accounts, but, as we saw, not completely safe.

A narrow bank is completely safe. And with the option of a narrow bank, the only reason for companies to invest in these other arrangements is to try to harvest a little more interest. Regulators can feel a lot more confident shutting down run-prone alternatives if a narrow bank is widely available.

The most common objection to equity-financed banking is that people and businesses need deposits. Well, narrow banks provide those deposits, and can do so in nearly unlimited amount. Narrow banking, providing completely safe deposits, opens the door to equity-financed banking, which can invest in risky assets and also be immune from financial crises.

Why not just start a money market fund that invests in treasuries? Since deposit -> narrow bank -> Fed -> Treasuries, why not just deposit -> money market fund -> treasuries, and cut out the middle person? Well, a narrow bank is really a bank. A money market fund cannot access the full range of financial services

This article was written by

John Cochrane profile picture
John H. Cochrane is the AQR Capital Management Distinguished Service Professor of Finance at the University of Chicago Booth School of Business. His recent finance publications include the book Asset Pricing, and articles on dynamics in stock and bond markets, the volatility of exchange rates, the term structure of interest rates, the returns to venture capital, liquidity premiums in stock prices, the relation between stock prices and business cycles, and option pricing when investors can’t perfectly hedge. His monetary economics publications include articles on the relationship between deficits and inflation, the effects of monetary policy, and on the fiscal theory of the price level. He has also written articles on macroeconomics, health insurance, time-series econometrics and other topics. He was a coauthor of The Squam Lake Report. He writes occasional Op-eds, and blogs as “the Grumpy Economist” at johnhcochrane.blogspot.com. Cochrane is a Research Associate of the National Bureau of Economic Research and past director of its asset pricing program, a Senior Fellow of the Hoover Institution at Stanford University, and an Adjunct Scholar of the CATO Institute. He is a past President and Fellow of the American Finance Association, and a Fellow of the Econometric Society. He has been an Editor of the Journal of Political Economy, and associate editor of several journals including the Journal of Monetary Economics, Journal of Business, and Journal of Economic Dynamics and Control. Recent awards include the TIAA-CREF Institute Paul A. Samuelson Award for his book Asset Pricing, the Chookaszian Endowed Risk Management Prize, and the Faculty Excellence Award for MBA teaching. Cochrane currently teaches the MBA class “Advanced Investments” and a variety of PhD classes in Asset Pricing and Monetary Economics. Cochrane earned a Bachelor’s degree in Physics at MIT, and earned his Ph.D. in Economics at the University of California at Berkeley. He was at the Economics Department of the University of Chicago before joining the Booth School in 1994, and visited UCLA Anderson School of Management in 2000-2001. In addition to research and teaching, Cochrane is a competition sailplane pilot and windsurfs. He lives in Chicago with his wife Elizabeth Fama and children Sally, Eric, Gene and Lydia. For more information, please see Cochrane’s website, http://faculty.chicagobooth.edu/john.cochrane/

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Comments (2)

"Banks do not loan out existing deposits, saved or otherwise"

Of course not. Why would they go to all the trouble and expense to accept deposits and deal with customers (they're really an expensive pain) when they could more cheaply and easily
make loans your way?

What way was that again?
Salmo trutta profile picture
The author dismisses the actual accounting impact / the economic malady created.

Banks do not loan out existing deposits, saved or otherwise. A little knowledge is a dangerous thing.
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