Narrow Banking and Conscripted Banking

Why would libertarians want to get rid of normal banking?

In the latest issue of the Cato Institute’s Magazine, Paul Godek writes,

Currently, banks are required to keep only a small fraction of their deposits as “reserves” with the central government bank, the Federal Reserve. Banks are free (though subject to voluminous regulations) to loan out and otherwise invest the rest of their deposits. Hence, the system is known as fractional reserve banking. (The regulations are there to prevent banks from taking excessive risks with depositors’ money, which sometimes works, sometimes doesn’t, but more on that below.) Narrow banks, in contrast, would keep all deposits at the Federal Reserve or invested in short‐​term U.S. Treasury bills.

Many people with libertarian credentials like the idea of narrow banking. Tyler Cowen is one. John Cochrane is another. I do not share their enthusiasm.

I see fractional reserve banking as normal banking. Normal banks profit from the spread between the interest rate on a risky, long-term asset, such as a commercial loan, and a deposit which consumers treat as a riskless, short-term liability of the bank. Normal banking raises the level of investment in the economy.

A normal bank is solvent but illiquid. Its loan decisions on average are profitable and good for the economy. If depositors only withdraw their funds as needed, the bank’s assets will eventually earn more than enough to pay depositors in full. But if depositors run and the bank has to sell assets in a hurry, then the bank will have to sell its loans to investors who have not had time to evaluate the ability of borrowers to repay. It will have to sell assets at a steep discount, forcing the bank out of business.

To operate as a narrow bank, matching deposits with assets means holding only short-term, risk-free assets. Contemporary advocates of narrow banking always use U.S. Treasury securities as the riskless short-term asset that a narrow bank should hold.

I call narrow banking conscripted banking. A narrow bank could not make the sort of loans to the private sector that a normal bank can make. Narrow banking means funneling consumer deposits into the hands of the government.

My reading of Niall Ferguson’s The Cash Nexus is that banks and government tend to lean on one another in any functioning financial system. In the United States, we have come to use government-provided deposit insurance to bolster normal banking. To address the moral hazard of deposit insurance, the government regulates banks. This in turn gives the government leverage over bank lending policy, enabling government to induce banks to hold government securities.

But at least the present arrangement still allows banks to do some lending to the private sector. If only narrow banking were permitted, then banks would be forced to do all of their lending to the government. Banks would become pure public utilities.

To be fair, eliminating private sector lending is not the goal of those who advocate narrow banking. Most proponents assume that loans to the private sector would still take place. This lending would be undertaken by nonbank institutions, which would not be issuing short-term deposits.

For example, private equity firms make long-term investments using funds that cannot be withdrawn for several years. But if all non-government lending used the private equity model, a profit opportunity would beacon. A new intermediary would emerge to write contracts with private equity investors that allow those investors to sell or borrow against their holdings at a moment’s notice. This new intermediary would earn a fee for this service. But it would not be able to honor all of its contracts at once. It would, like a normal bank, be solvent but illiquid.

The profit opportunity in normal banking cannot be suppressed. Instead, what libertarians should be looking for are ways to reduce the proportion of savings that is conscripted by the government. Advocating for more market-friendly bank regulation is one approach. But the ultimate need is to reduce government spending and budget deficits, so that government has less need for conscripted banking.

This essay is part of a series on human interdependence.