Narrow Banks Won't Stop Bank Runs

Every financial crisis leads to a new call to restrict the activities of banks. One frequent response is to call for “narrow banks.” That is, change the legal and regulatory framework in a way that severely limits the assets that traditional deposit-taking banks can hold. One approach would require that all liabilities that are demandable at par be held in the form of deposits at the central bank. That is, accounts that can be withdrawn without notice and have fixed net asset value would face a 100% reserve requirement. The Depression-era “Chicago Plan” had this approach in mind.

In the aftermath of the financial crisis of 2007-09, Lawrence Kotlikoff, Jeremy Bulow and Paul Klemperer, John Kay, and, most recently, John Cochrane, and Martin Wolf have resurrected versions of narrow banking. All of these proposals, both the old and the new, have a common core: banks should be split into two parts, neither of which would supposedly be subject to runs.

The first part is a narrow bank that provides deposits that are as safe as a central bank asset; the second operates like a mutual fund or investment company in which any risk of fluctuation in the value of the assets flows directly through to the ultimate investor. Aside from these common elements, the proposals are distinguished by how (or whether) they assure the supply of liquidity demanded by the public, and how (or whether) they thwart the entry of “runnable” shadow banks. Doing the latter would require another government intervention, such as Cochrane’s proposal for a tax on runnable short-term debt (conceptually similar to the 1863 levy on note issuance by state-chartered banks).  

Naturally, we share the objective of these reformers: preventing bank runs. The key issue is how to do so and at what cost. We suspect that narrow banking would be costly in terms of economic performance, yet unlikely to achieve this goal.

Banks as we know them – deposit-financed lending institutions with “fractional” rather than 100% reserves – first made an appearance in late medieval and early Renaissance Italy. They have been operating for nearly a thousand years. No country today requires 100% reserves, nor are we are of any major jurisdiction that ever has. The reason is pretty clear:  traditional banks are extremely useful.

Banks serve capitalist economies in two ways that are costly to replicate. First, they are experts in providing liquidity both to depositors and to borrowers. For the former, it is deposits and for the latter, lines of credit (such as home equity loans that can be used when the borrower needs the funds). Second, they have expertise both in screening potential borrowers and then in monitoring those to whom they make loans. That is, they specialize in mitigating the information problems that plague all financial transactions.

Narrow-banking proponents correctly insist that these functions can be carried out without having risk reside on the balance sheet of the intermediary. However, the need to tax potential entrants (shadow banks) suggests that the service to the economy of lending out demand deposits is nontrivial.

This brings us to the main point: would narrow banking really eliminate runs?  Would it solve the fragility problem its proponents suggest is a consequence of fractional reserve banking?  Our short answer to these questions is no. The mutual funds of the narrow banking world would be subject to the same runs. Indeed, recent research highlights that – in the presence of small investors – relatively illiquid mutual funds are more likely to face exit in the event of past bad performance. Thus, in practice, illiquidity plays the same role in a world of mutual funds with many investors as it does in the classic Diamond-Dybvig model of a bank run.

And, without deposit insurance, the runs could be both more frequent and more devastating. Even modest declines in confidence, for reasons that are either real or imaginary, could readily turn into panics.  Since the mutual funds would be holding illiquid loans – remember, they are taking over functions of banks – collective attempts at liquidation to meet withdrawal requests would lead to ruinous fire sales.  After this happened even once, people would simply flock to the narrow banks, and there would be no source of lending. That is, a financial panic in a system with narrow banks would devastate the credit intermediation process.

Such a credit crisis probably also would trigger a massive government intervention to support the not-so-narrow intermediaries. As a result, the government’s initial commitment to let the not-so-narrow funds fail in a crisis would not be credible, adding to the funds’ incentive to take on credit and liquidity risk and – contrary to the goals of narrow banking – raising the probability and cost of a future crisis. In short, we suspect that narrow banking lacks time consistency.

We know that a combination of transparency, high capital and liquidity requirements, deposit insurance and a central bank lender of last resort can make a financial system more resilient. We doubt that narrow banking would.