Irreverent Economics

Some proposals for reforming the financial system after the current financial crisis are based on narrow banking. The idea is that banks should be limited in what they can do, perhaps along the lines of the Glass-Steagall act in the US. The Glass-Steagall act separated financial institutions into investment banks and commercial banks, with the idea that investment banks take on more risk, while commercial banks provide regular banking services for most of the economy.

Other proposals would have banks split up along with client groups, so one type of bank services regular customers, another small and medium-sized enterprises, and so forth. The idea is that if such a bank is prohibited from investing in risky assets and proprietary trading it is less likely to fail and the financial system becomes more stable.

I don’t agree.

Of the sophisticated financial economies, the country that has most assiduously practiced narrow banking is the US. Not only did it have the Glass-Steagall act, its banks have been restricted along various geographic and business lines. Furthermore, because many banks there are state (not federally) regulated, and we have a great variety in how the individual states approach regulation, we can compare different regulatory regimes.

In spite of these narrow banking regimes, the US has experienced more banking failures than any other sophisticated financial economy, and has experienced a full blown crisis in one of its banking sectors, the Savings and Loans in the 1980s.  It even had to bail out some of its investment banks. The empirical evidence from the US does not indicate that narrow banking is safer than universal banking.

Some of the reasons why universal banking is no riskier than narrow banking, and even safer are:

A narrow bank is more concentrated in its activities and operates in an environment of many similar banks. Of course, it still has to make profit and to do that has to assume risk. Because it’s risk-taking activities are narrowly concentrated, it is more vulnerable than more diversified banks. Because other banks in the same sector operate in the same competitive environment, competition can drive them to more risk-taking, and if one institution is in trouble it is quite possible that others are as well. The potential for systemic events within a particular narrow banking sector increases.

It is unlikely that a narrow bank can provide all the services client needs. For example, a typical individual bank clients need current account services, loans,credit cards, mortgages, investments, etc.  Depending on how narrow we choose to make the banks, an individual customer may need to go to multiple institutions to get the banking services they currently can get from one bank. Furthermore, some of these services are more profitable to provide than others, and some are more risky. There is no evidence that a customer would get better services this way, nor that the banks would be safer. The evidence points to the opposite. Narrow institutions specalizing in mortgage services have not bewn proven to provide better services or be safer than more diversified institutions, rather the opposite.

For financial institutions providing banking services to firms, the picture is even more complicated. Even small firms may need access to sophisticated financial service, such as investment banking, hedging and international banking. Any bank providing such services needs to have the expertise in-house, and the ability to hedge away risk. That means sophistication and proprietary trading.   Enforced specialization along narrow banking lines is unlikely to enable firms to receive the gamut of backing services they need, whilst enabling banks to hedge their risk  via proprietary trading or diversification.

If individual clients wanted banks to be narrow, in a competitive banking environment such banks would exist. The fact that they generally do not, suggests that banking services from a financial system that enforces narrow banking would not provide better services to clients. If banks are narrow, they are likely to be less diversified and possibly more risky. Because the banks will be more similar, there is a higher risk of systemic crisis. For these reasons, I think narrow banking is a bad idea.

I was a witness for the the Future of Banking Commission, for Which today. I disagreed with the other panelists on issues such as narrow banking and the need for regulatory reform.  The video is here under the heading “Academics”.