Narrow Banking Concept and Its Potential to Improve Financial Stability

Narrow banking is a concept that aims to improve financial stability by separating traditional banking from investment banking. This separation is achieved by creating two separate institutions: one for accepting deposits and providing loans, and another for investing in securities.

The idea behind narrow banking is to prevent banks from engaging in high-risk activities that can lead to financial crises. By limiting their activities to traditional banking, narrow banking aims to reduce the risk of bank failures and promote financial stability.

In a narrow banking system, deposits are insured by the government, providing a safety net for depositors. This is a key feature of the narrow banking concept, as it helps to maintain public trust in the banking system.

Narrow banking has been proposed as a solution to the problem of bank failures, which can have far-reaching consequences for the economy.

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Narrow banking has its roots in early thought leadership, with notable figures like Sankarshan Acharya, Ph.D., from the University of Illinois at Chicago, publishing a paper titled "Safe Banking" in 2003. Acharya's work laid the groundwork for future discussions on the topic.

Kevin James from the Bank of England also made significant contributions, presenting a slide presentation to the Banco Central do Brazil in 2007. His presentation, titled "The Case for Narrow Banking", highlighted the potential benefits of a narrow banking system.

In 2019, the Federal Reserve denied approval for narrow banking in the U.S., citing concerns that it would disrupt monetary policy, threaten the repo market, and create financial instability.

The Chicago Plan had a strong following, with Irving Fisher being a key supporter of the idea. This plan would implement 100% reserve banking.

In 1939, a document was written that outlined the Chicago Plan's key points. Another excellent read on the subject is Ronnie Phillips' "The 'Chicago Plan' and New Deal Banking Reform."

Henry Wallace, the Secretary of Agriculture, handed the plan to President Roosevelt in 1933, praising its merits. He wrote, "The memorandum from the Chicago economists which I gave you at [the] Cabinet meeting Tuesday, is really awfully good and I hope that you or [Treasury] Secretary Woodin will have the time and energy to study it."

The Chicago Plan proposed some significant changes to banking. Here are its main points:

The Revisited Chicago Plan is a proposal that aims to split banks into two parts, neither of which would be subject to runs.

Stephen Cecchetti and Kevin Schoenholtz, as well as Frances Coppola, agree that this proposal has a common core: a narrow bank that provides deposits as safe as a central bank asset, and a second part that operates like a mutual fund or investment company.

In the strict 100% reserve banking proposal, all deposits are backed by central bank reserves, regardless of the depositor's risk appetite.

The Kotlikoff plan envisions a disintermediated banking system where banks market various types of funds but do not themselves do credit intermediation or maturity transformation.

John Cochrane suggests that institutions wanting to take deposits, borrow overnight, or issue runnable contracts must back those liabilities 100% by ST Treasuries or reserves at the Fed.

Institutions that want to invest in risky assets, like loans or MBS, must fund those investments with equity and long-term debt.

John Cochrane argues that Pigouvian taxes provide a better structure for controlling debt than capital ratios or intensive discretionary supervision.

By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important, and issuers will economize on them endogenously.

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The narrow banking concept is a bank structure that excludes investment banking activities, similar to the "banks" during the Glass-Steagall era.

This structure is characterized by running loan books but not participating in fractional reserve banking, which means not printing money.

The more narrow definition of narrow banking is close to what can be achieved with Central Bank Digital Currencies (CBDCs), depending on how they are implemented.

CBDCs are still in pilot mode in a few jurisdictions and are much discussed, but responsible central bankers consider implementing them a political decision, not a central bank decision.

Most Western governments have historical debt levels that keep growing to new highs, and a sceptical treasurer may have reservations about even central bank money.

Narrow banking offers a secure store of value for corporates, with central bank funds being the most secure and liquid option available. This is because central bank funds remain the most secure and liquid store of value potentially available to treasurers.

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In the past, large corporates have applied for banking licenses to gain access to central bank deposits, but this is an expensive and complex method that's only available to very large corporates.

A narrow bank offers near direct access to central bank funds, making it a more accessible and cost-effective option for corporates.

Here's a breakdown of the benefits of narrow bank deposits:

Narrow bank deposits also offer lower costs compared to other investment options, such as securities, gold, and cryptocurrencies.

Risk Management is crucial in narrow banking. It helps prevent bank runs by limiting the bank's ability to take on excessive risk.

One way narrow banking achieves this is by separating commercial and investment banking activities. This separation reduces the risk of bank runs and maintains financial stability.

By limiting the types of assets banks can hold, narrow banking minimizes the risk of bank failure. This is achieved through the use of reserve requirements and other regulatory mechanisms.

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In narrow banking, banks are required to hold a certain percentage of their deposits in reserve. This reserve requirement helps maintain liquidity and prevents banks from over-extending themselves.

The goal of narrow banking is to create a more stable financial system. By reducing the risk of bank failure, narrow banking promotes economic growth and stability.

In conclusion, narrow banking is a viable solution to the financial crisis, as it separates traditional banking activities from investment banking, reducing systemic risk.

The key takeaway from this approach is that it allows banks to focus on their core functions, such as accepting deposits and making loans, without engaging in high-risk investment activities.

By doing so, narrow banking can help prevent future financial crises and promote financial stability.

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It may take a while to become common, but simpler banking can offer many benefits for treasurers and their employers.

Simpler banking, especially narrow banking, can help improve corporate treasury performance.

Clients located all over the world rely on Acarate to help improve corporate treasury performance.

Acarate provides consultancy on all aspects of treasury, including policy and practice, cash, risk, and liquidity, and technology management.

Acarate also offers leadership and team coaching as well as treasury training to make organisations stronger and better performance oriented.

In the banking industry, a substantial inefficiency occurs when banks maintain less than a one-hundred percent reserve requirement, exposing depositors to risks like investment risks and bank runs.

This inefficiency is rooted in the fact that depositors with uncertain liquidity needs can't find riskless banks that will store their money without exposing them to risk.

The crisis of Scandinavian banks during the early 1990s and the S&L crisis in the US during the 1980s are prime examples of the risks associated with this system.

Banks often bundle deposit accounts with risk-taking activities, leading to a substantial welfare loss.

Deposit insurance policies don't eliminate this inefficiency, and consumers are left to deal with the consequences.

The rapid development of securities markets can actually expand consumers' saving and investment opportunities, despite lending restrictions imposed on banks.

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