Matt Levine on Banking

are we seeing "narrow banking"?

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Matt Levine writes,

This business — “fractional reserve banking,” it is often called is inherently risky and fragile. Everyone knows this, and there are standard methods to mitigate the risks. Banks have capital requirements (they are partly funded with equity, not deposits, so if the assets lose value the depositors still get their money back). They have liquidity (some of their assets are short term and safe, so if depositors want money back there’s some money to give them). There is safety-and-soundness regulation and supervision (the government tries to prevent banks from making loans that will lose money). There is deposit insurance (the government promises that depositors will get their money back, making bank accounts safer and runs less likely). Still there is some unavoidable residue of fragility: The mismatch between the banks’ safe short term liabilities and their risky long term assets creates risk, and somebody — if not depositors then the government — has to bear that risk.

He points out that periodically some economists (I’m looking at you, John Cochrane) say that banks should be forced to hold only short-term, low-risk assets against deposits. This is called “narrow banking.” Levine writes,

Meanwhile, risky loans would come from people who intend to make risky loans: You could have, say, a loan fund that raises money from investors, locks up their money for 10 years, uses the money to make 10-year loans, and then pays back the investors whatever the fund gets back on the loans.[4] If the fund makes bad loans, the investors lose money; they bear the risk knowingly and directly, unlike bank depositors who sort of don’t know where their money is going.

But this is not where I think the industry would end up. Somebody, somewhere would notice that they could make a profit by engaging in liquidity transformation. That is, liabilities walk in the door that are long-term and risky, and liabilities walk out the door that are short-term and riskless, and nobody is the wiser.

The point of his article is that with the Fed’s “reverse repo” program, money market funds can act like narrow banks and have fun doing it.

A money market fund that just parks its money at the Fed has essentially no risk: All of its assets are short-term (they are parked overnight) and safe (its debtor is the Fed), so your money is safer there than it is at a bank. It has few expenses: It doesn’t need a branch network or a lot of lending officers to take in money online and park it at the Fed, so it can pass on most of the interest that the Fed pays it directly to its customers. And the Fed does pay it a lot of interest — reverse repos pay something like 4.8% — so it can end up paying depositors more interest for taking less risk than a bank can.

Ironically, the Fed makes it easier for money market funds to be narrow banks than it is for actual banks to be narrow banks. Go figure.

I am more optimistic than Levine about the viability of liability transformation. I have a piece scheduled to come out this summer that will explain how it could be managed. But I have serious doubts about the existing institutional structure, anchored by the FDIC, in terms of its ability to manage a regime with banks undertaking liability transformation.