I'm for the narrowing of banking. The idea that depositors are being magically convinced to take on more risk than they intend to just by pooling everyone together and relying on timing differences always redounds back to the government to prop up. (liability transfer is not much different from check kiting)

I agree that quantitative easing is a trap we've found ourselves in, and I'm not sure how we unwind that, but I take the positive view on central bank digital currency. If every citizen had an account with the Fed, property rights to that money would be clearer and stronger. People point to the actions of the Canadian govt during the trucker protests, but there the government was able to freeze funds precisely because they were tied up with third-parties.

If basic property rights in a bank account are at risk, we have bigger problems than we think.

You give examples of how money is pooled and put to use in the real economy. That process is working fine.

The amount of money tied up in financial contracts dwarfs the amount of money in the real economy, so raising money for investment in actual things is not the issue. All of the debt created via QE is the bigger threat.

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I agree with your point that QE seems to be the bad version of narrow banking, so much so that it might be best to separate it entirely from the standard narrow banking business model, much like how one might separate "retirement savings plan" and "Social Security".

I am a little confused on your point regarding central bank digital currency, though. Are you arguing that Canada having that in place would have made their citizens' money more secure and protected from government over reach, or that they were equally screwed no matter what?

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Jun 5, 2023·edited Jun 5, 2023

My point is that property rights in a bank account tend to be secure (I'm mostly talking about the US, but the Canadian trucker thing comes up alot).

The extent to which the government can freeze your bank account is a separate issue from it being digital (it already is digital) and being directly at the Fed.

Right now when dollars are put into the system it's done through intermediary banks and results in debt that piles up and crashes.

If instead each person had a bank account with the Fed, the government could create new dollars by putting them directly into people's accounts. And these deposit accounts would be perfectly narrow.

In "Another Now" Yanis Varoufakis posits a system like this.

I mention the Canadian truckers because the way I understand it (could be wrong), the government was able to freeze money precisely because it was tied up with third parties.

The idea that this simpler banking system would be license for the government taking people's money based on speech or whatever is a plain old property rights issue.

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Thanks for the clarification!

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"With only narrow banking, there would be less investment, and economic activity would be crippled."

It's not clear to me why this would have to be the case. Let's say everyone with a bank account today suddenly got their money back and were told they could either put it into equities or into a vault that basically charged a negative interest rate to keep their money safe. It isn't obvious to me that an allocation with less investment than before would be the inevitable result. While it could go either way, shouldn't an allocation reflecting previous appetites be the expected result?

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Was gonna post exactly this. Arnold makes a bare assertion here without proof.

“The only stable foundation for a financial system is misleading depositors about the safety of their deposits.”

Sorry, I just can’t hop on board that train.

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Jun 6, 2023·edited Jun 6, 2023

Matt Levine of Bloomberg, does a free e-mail newsletter called Money Stuff (3-4 times a week).

He covers all of this in much clearer terms for the layperson (i.e. someone who can understand the the financial press but doesn't follow it closely.

And he's hilarious.

He talks about how banking really has been an issue of misleading depositors about risk. The key point is that this is all based on timing issues and ultimately has to be backed up by the government.

But as sk (above) says, this isn't really the financing model used these days.

So we could, if we wanted, have perfectly narrow banking for cash account depositors by giving everyone an account with the Fed (similar to the vault idea).

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I have always been puzzled by this claim, too. Investments can essentially be financed by equity or credit, although there are lots of hybrids, and credit could function without maturity transformation or monetary creation. So what exactly are the economic benefits of maturity transformation? See my point below for a possible answer.

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Well, the banking system run as per Basel III is basically a spreadsheet that doesn’t need any management. Maturities transformation is highly penalized and in fact the explosion of the shadow banking system is the result. You really wonder what is the purpose of commercial banking today considering that payments can be managed in different ways, loans are provided by BDCs, direct lending funds....mortgages is the only thing left.

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Once upon a time banks while not explicitly engaged in narrow banking more resembled that kind of model vs what the business model is for most of them today. In that long ago era, long term loans were the exception, not the rule both for commercial lending and commercial real estate lending which was mostly for construction loans with take-outs from insurance companies. All that changed over time due to disintermediation, and banks needing to find profitable outlets, at least the large banks at the time changed the business model to allow for LBO loans and longer term commerical real estate loans, a term loan on top of the construction loan; thus the bank becoming its own take out lender. Moreover, with so many banks competing for borrower dollars equity requirements of borrowers dropped. Net, a large change in the balance sheet of banks across the industry.

Safeguarding deposits of the public given that banks today are not really banks, but diversified financial service firms should be front and center. Deposits that fund short term C&I loans like in days gone bye done in a subsidiary of Hold Co will safeguard depositor assets and all risk taking can take place at the Hold Co level funded by equity and non depositors debt providers.

I believe the insurance industry safeguards the premium payers from the risks that an insurance company takes with assets it buys with risk taking not at same subsidiary level as where premiums are paid in to. Some upstreaming of funds , but capital requirements of the sub that receives premiums is quite high and if an issue arises with the insurance company, regulators are quite quick to seize the sub and sell it to another insurance company with little to no fanfare. Yes , the businesses are not totally comparable , but in todays financial industry there should be better safeguarding of customer deposits.

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A history of the evolution of banking broken up by culture or geography or economies or other ways to segment bank evolution could be an interesting read. More so then narrow thinking banking imho.

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One benefit of maturity transformation is the protection it provided against theft in the old times (think massive gold reserves in your vault waiting to be robbed) or against the inflation tax nowadays (think huge central bank reserves on your balance sheet). Wouldn’t narrow banking create an incentive to inflate-the equivalent of robbing the vaults of commercial banks?

For example, the Fed buying $1 trillion of assets would have been difficult when the balance sheet was $500 billion. Now that it is more than $6 trillion, it is doable and it has been done.

Now, imagine we go all the way Chicago-style narrow banking, when the Fed’s balance sheet would be several times larger! Plus, there would be little or no multiplier effect by commercial banks. I believe it would be politically impossible to resist the temptation of inflating the base, in order to collect a large seigniorage while the impact on the global money supply would be damped.

Does this sound right?

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Jun 5, 2023·edited Jun 5, 2023

It is true that the Fed is paying out more interest on its mostly shorter term liabilities than it is taking in on mostly longer term liabilities. It's also true that if banks make this liability transformation, their capital is on the hook and they would have more incentive to be concerned about the losses.

That said:

1 I have some 30 year Treasury bonds with another 10 years paying 8% interest. Are you similarly concerned by that?

2 I kind of think you are making an apples and oranges comparison.

2a If the Fed only bought treasuries, they would be printing money to buy US debt. Ignoring market distortions, which doesn't seem to be your concern, I don't see it matters what rate they are paid on bills or bonds. It's printed money where govt is essentially paying itself. Buying other debt is really only different in secondary ways like distorting supply of govt versus other debt. It's still the same as far as liability transformation.

2b Back in 2008, Congress and the Fed CHOSE to start paying interest on bank reserves. I'm not sure I understand why they decided to do this but unlike a commercial bank, they aren't paying interest in order to have funds to buy bonds.

(I'm sure it would be a huge controversy but they could stop paying interest on required reserves, excess reserves, or both.)

3 I don't really think the Fed's interest income and interest paid are comparable. They pay interest on whatever banks decide to deposit and buy debt with money they print. Yes, maybe the two actions counter each other and QE likely results in more bank reserves (exact opposite cause and effect than other banks) but they are doing these actions for different purposes.

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However Tyler’s first objection makes little sense. At some price supply and demand for safe assets clears

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Sorry, Arnold. Nobody has proposed a financial system based ONLY on narrow banking. If I'm wrong, please give me the reference.

Also, narrow banks are banks funded only with deposits that can be redeemed at par any time AND the deposits are backed 100% by a reserve of liquid assets --yes, the problem is liquidity. You should be discussing what liquidity means in this context and which assets would/could be liquid enough to qualify. Do you think gold is liquid enough to be such a reserve?

Finally, you should discuss directly whether the new payment systems of the past 25 years have disrupted the old idea of narrow banking or not.

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I believe the so-called Chicago plan suggested by Henry Simons in the wake of the Great Depression was the last proposal based entirely on narrow banking.

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I can see the power of your arguments AGAINST Narrow Banking. But after the "crises" of 2008-09 It seems clear to me that banking regulations never will be sufficient to antcipate the cascade of financial innovations from banking. At least, the arguments in John Kay, "Narrow Banking" and the "reasons" Professor Bernanke gave on the formentioned "crises" in his Nobel Address speach confirm that.. Regards. PS. I always read your brief essays. Thank you for share yout ideas.

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The analysis confounds term transformation with interest rate mismatch. Banks could still take sight deposits and invest in credit risky variable rate assets. It's kind of surprising that regulators let them mismatch rates so badly.

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