Why Narrow Banking?

It is not such a healthy development

Tyler Cowen recently wrote,

the narrow banking model has long been plagued by two major problems. First, there have never been enough safe assets to satisfy the demands of depositors. Second, excessive investment in government securities tends to crowd out private investment. The rise of narrow banking can in part be explained by the mitigation of both these issues.

Narrow banking means banking without liability transformation. A narrow bank has liabilities that match the characteristics of its assets. If it has long-term assets, it issues long-term liabilities. If it has risky assets, then it issues liabilities that are also risky. It does not hold risky, long-term assets and issue purportedly riskless, short-term liabilities.

Liability transformation is performed with debt. A bank makes risky, long-term loans (or buys corporate bonds), funded with deposits that can be redeemed at par any time.

If we only had narrow banking, then the financial sector would consist almost entirely of two types of claims: money, backed by 100 percent reserves; and equity. There would be much less debt issued.

Cowen cites two developments that seem to point in the direction of narrow banking. One development comes from “quantitative easing,” which creates an apparent abundance of safe assets to act as reserves for short-term deposit accounts. By paying interest on reserves, the Fed stuffs banks with short-term assets backed by the government. Also, by undertaking “reverse repo” with investment banks, the Fed gives money market funds plenty of short-term riskless assets as well.

With interest on reserves and reverse repo, there is still liability transformation going on. It is just that the Fed is replacing the private sector in doing it. The Fed has accumulated on its balance sheet vast amounts of long-term bonds and mortgage securities, and it is financing these with very short-term obligations. The risks of the Fed’s liability transformation are now apparent, as the rise in interest rates have caused the central bank to incur over $500 billion in losses. Ultimately, taxpayers will bear the burden of these losses, just as we would if the private banking system incurred $500 billion in losses and the government felt obligated to reimburse depositors (although bank shareholders would absorb some of the loss as well).

The other development that seems to point int the direction of narrow banking is the growth of private equity. Rather than engage in liability transformation, private equity firms raise long-term funds with uncertain returns in order to finance risky, long-term investments.

The alternative to financing projects with private equity is to finance them with old-fashioned public equity and with bank loans. But tapping the public equity market subjects firms to large regulatory risks, and, as Cowen points out, banks also has become increasingly regulated.

What I call the regulatory taxes that the government has imposed in recent years would, other things equal, reduce the amount of liability transformation undertaken by the financial sector. But keep in mind that there are also government subsidies to liability transformation. Deposit insurance and “too big to fail” subsidize liability transformation by banks. And the favorable tax treatment of debt relative to equity induces firms to finance more of their operations with loans and bonds than they would otherwise. Risky, long-term corporate debt is then transformed into riskless, short-term liabilities of banks.

I don’t believe that we will ever see a financial sector predominantly consisting of narrow banking, with little or no liability transformation. Nor should we want to see such a development. With only narrow banking, there would be less investment, and economic activity would be crippled.

With a lot of liability transformation, debt finance will be higher than it would have been otherwise. Up to a point, this will be a good thing, allowing the private sector to undertake more economically viable investment. Beyond a certain (unknown) point, liability transformation will fuel over-investment and malinvestment, setting the economy up for a crash.

In theory, government regulators could observe the cycle in liability transformation and try to dampen it. Ideally, you would increase the subsidies for liability transformation and lower the taxes on it when investment is too low. And you would decrease the subsidies and increase the taxes when investment is too high.

In practice, of course, what we have are a patchwork of regulatory subsidies and taxes that work at cross-purposes with unknowable effects. I do not believe that anyone can calculate whether financial regulation as it exists serves to dampen cycles or exacerbate them, although if I had to bet I would wager on the latter.

I certainly do not believe that we should applaud the recent moves toward narrow banking. Shifting liability transformation from the private sector to the Fed via “quantitative easing” is a deplorable development. And so is the stifling of the public equity market by Sarbanes-Oxley and an overactive Securities and Exchange Commission.

This essay is part of a series on human interdependence.