Potential Problems With Narrow Banking

Here’s an interesting post from John Cochrane on “narrow banking”. Narrow banking is the idea that we could create banks that take a “narrow” type of risk by investing only in very high-quality assets like Central Bank reserves or government bonds. This would back the bank’s balance sheet with virtually risk-free assets. The argument is that this would be ideal compared to modern banks because there would be no risk of runs and no need for bailouts.

As the Cochrane post discusses, the Federal Reserve has apparently rejected an application for a narrow bank which has subsequently resulted in a lawsuit. You might wonder why the Fed would reject an application for an entity that just wants to be a super safe bank, but I think there are strong arguments against this form of institution. I’ll explain some of my own concerns below, but I also reached out to a good friend of mine who works at a regional Federal Reserve bank and he explained to me why he finds the idea misguided. He asked to remain anonymous so I will pass on what he said:

“Narrow banking does not ensure low risk banking. A pure commercial bank is as risky as the loans it makes. Requiring a bank to fully reserve its deposits does not mean the bank’s total assets are safer. It just means their deposit liabilities have a safety net. For instance, if XYZ Bank issues bad loans during the financial crisis then the value of their assets relative to their liabilities will decline regardless of how safe the deposit liability side of the balance sheet is. In other words, narrow banking does not equate to narrow lending”.

Cullen here. That’s pretty clean. It’s oversimplified for emphasis, but you get the basic gist. This idea kind of reminds me of the idea of a full reserve system. We know that banks issue loans and find reserves after the fact. So, if a system is fully reserved then that just means the Central Bank must supply reserves when banks create new deposits. This doesn’t mean the loans themselves are safer. It just means the Central Bank is fully reserving the deposits.