Narrow bank

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Narrow banking is a proposed type of bank called a narrow bank also called a safe bank. Ultimately, if adopted widely, this could lead to an entirely new banking system. Narrow banks can, by risk reduction measures designed into the narrow bank, significantly reduce potential bank runs and the need for a deposit insurance provided by the central bank. It is sometimes suggested as an improvement upon fractional reserve banking.

Narrow banking would restrict banks to holding liquid and safe government bonds. Loans would instead be made by other financial intermediaries. That is, the deposit taking and payment activities have been separated from financial intermediation activities. Two different types of banks (financial companies) are needed, one for each activity.



Some early thought leaders in narrow/safe banking include -

1. Satyajit Das from the University of Illinois who published an early paper on the topic of narrow banking.
2. Mike Denoma who advocated the case for it early in his career (circa 2000)
3. Kevin James from the Bank of England who presented very early on in this debate

More recent references include the consideration of safe banks or narrows banks in the next round of Bretton Woods and the Feb 2009 World Economic Forum agenda titled The Future Of The Global Financial System.

Attributes of narrow banks

Key attributes of narrow banks include -

1. no lending of deposits (reducing a key risk materially but constraining return on investment for depositors and shareholders alike)
2. extremely high liquidity (tpyically short-term assets e.g. bonds)
3. extremely high asset security (typically government bonds)
4. lower interest rates paid to depositors (as a function of the no lending and other constraints)
5. possibly specific regulatory framework with higher level of scrutiny and operational/investing restrictions

Additional criteria applied to safe banks include -

1. no derivatives
2. no off balance sheet assets
3. high degree of institutional transparency (e.g. continuous real-time disclosure of financial records)
4. capped executive salaries
5. low risk jurisdictions

Narrow banking and investment banking: the Glass Steagall debate

"The third complex issue is the appropriate relationship between retail and commercial banking and investment banking activity, and in particular risky proprietary trading. It is clear that there is a problem which has to be addressed.

In the years running up to the crisis, we had large commercial banks taking the benefits of retail deposit insurance and perceived too-big-to-fail status and using these to support risky proprietary trading activities which created large bonuses for individual bankers but large costs to taxpayers and financial instability which has produced a recession. That is not acceptable: the question is not whether we need significant change but how to achieve it.

One way would be to enforce a legal separation between narrow banking activities and investment banking activities, re-imposing, or in some countries imposing for the first time, Glass Steagall type distinctions. And some legally enforced distinctions of economic functions are clearly possible – indeed we already have one in the UK, with building societies not allowed to participate in the full range of financial activities which banks can perform – certainly excluded from exotic investment banking activities and subject to limitations on the percentage of their balance sheet which can be invested in for instance commercial real estate. Having such a tier of clearly narrow institutions does make sense; and indeed in my report to the Chancellor on the Dunfermline Building Society, I raised the issue of whether perhaps the freedoms to perform functions beyond residential mortgage lending had been set too loose after the various deregulations of the 1980s and 1990s.

But the real issue is not what the existing very narrow institutions should be allowed to do, but what should be the freedoms for those large commercial banks which are involved in the provision of services not only to residential customers and SMEs, but also to large complex corporates operating in the global economy and therefore involved in the management of complex foreign exchange, interest and credit risk. Can we keep these banks out of the trading activities which played a role in the crisis by writing a law which defines what they can and cannot do?

I suggested in The Turner Review that this was difficult. The key point to recognise is that the activities which caused the crisis were not ones which had been previously defined, under for instance Glass Steagall, as clearly outside commercial banking – activities such as equity underwriting and distribution – but activities which seemed close to the core functions of commercial banks such as credit intermediation, liquidity provision and interest rate risk management. Much of what went wrong went wrong in activities which a commercial bank was free to perform even before Glass Steagall was dismantled. It is, I think, difficult to imagine applying a law which says that a commercial bank cannot hold fixed income securities in its Treasury portfolio, turn loans into securities for distribution but hold them until distribution is achieved, or use credit derivatives to manage credit risks. And you certainly cannot say that a commercial bank cannot take any proprietary positions, without making it impossible to perform necessary market-making functions in, for instance, foreign exchange and interest rate markets.

But once you have said that a commercial bank can do all of those functions, you have allowed it to do most of the activities which, pursued on a large scale and in a risky fashion, caused the crisis.

That is why my tentative conclusion in The Turner Review was that we could not proceed by a binary legal distinction – banks can do this but not that – but had to focus on the scale of position-taking and the capital held against position-taking. That is why the increases in trading book capital to which I referred earlier are so important. And such increases need to be applied to all trading activity by banks or non-banks, since even where those trading activities are performed by institutions which are not insured deposit-takers, large systemic risks can still result. That was the lesson of Bear Stearns and Lehman Brothers.

Where there may be a role for legal entity definitions, however, is in defining more clearly the separate legal entities in which core retail banking functions and investment banking type functions are performed, ensuring that the retail banking functions are adequately and independently capitalised, and making it clear to the market that in any future crisis there is at least the possibility that rescue might apply only to retail banking operations. Such ideas have been floated, for instance, by Philipp Hildebrand, Vice-Chairman of the Governing Board of the Swiss National Bank. They would not be straightforward to implement, but they deserve careful consideration.

Macro-prudential analysis and tools

In the years running up to the crisis – in, say, 2002 to 2007 – we needed an analytical approach would put together the dots of the macro-prudential picture. In the UK that picture was of a growing current- account deficit, rapid credit growth, rapidly rising house and commercial real estate prices, the rapid growth of securitised mortgages, rapidly growing banks dependent on wholesale funding, and extensive reliance on funding from abroad, both via interbank funding and via US purchases of securitised mortgages, a reliance on funding from abroad which in turn, of course, was the flip side of the current-account deficit. We needed to do that analysis, identify the emerging risks, and then take offsetting actions. But we had in place neither the analytical approach nor the regulatory tools. We need to put them in place for the future.

If the overall principle is clear, however, much work is still needed to define how precisely macro-prudential regulation will operate. There are important questions in respect to objectives, to tools, and to the choice between hardwired and discretionary approaches.

On objectives, a crucial issue is how ambitious we should be. Are we simply aiming to increase the resilience of the financial system, reducing the likelihood of bank failure? Or do we believe we can reduce the amplitude of economic cycles, more effectively leaning against the wind of asset price bubbles, using other instruments than the interest rate to take away the punch bowl before the party gets out of hand? The more the objective is the latter, the closer the required links to the conduct of monetary policy.

On tools, one clear priority is a countercyclical approach to capital at the institutional level. But it is also possible to envisage both the definition and then the through-the-cycle-variation of margin requirements in secured lending, and of loan to value (LTV) or loan-to-income (LTI) ratios in, for instance, residential mortgages. Such approaches are essentially ways of regulating leverage at the product specific rather than the institution specific level. But establishing and then varying maximum LTV or LTI ratios in mortgages, raises complex issues relating to consumer access, and overlaps with conduct of business concerns. The FSA will make a contribution to that debate in the Discussion Paper on the mortgage market, which we will issue in October.

Finally, there is the issue of whether macro-prudential tools, and in particular countercyclical capital adequacy, should be varied in a discretionary fashion or hardwired, through, for instance, a Spanish dynamic provisioning type approach. The issue of hardwired countercyclical rules is already being considered by the Basel Committee, and the conclusions they reach on that issue may in turn have implications for the balance between hardwired and discretionary elements within the UK approach.

UK's King calls for break-up of banks

Mervyn King, governor of the Bank of England, called on Tuesday night for banks to be split into separate utility companies and risky ventures, saying it was “a delusion” to think tougher regulation would prevent future financial crises.

Gordon Brown rebuffs Mervyn King's suggestion on banks

Mr Brown told MPs that "the difference between having a retail and investment bank is not the cause of the problem."

The Prime Minister added that "the cause of the problem is that banks have been insufficiently regulated at a global level."

Mr Brown was responding to Mr King's fiercest attack yet on big banking in a speech he gave in Edinburgh last night. Mr King indicated the country's high street banks should be separated from their risky investment banking arms.

"“It’s clear King’s not happy with where we are now,” Colin Ellis, an economist at Daiwa Securities told Bloomberg. “He said the regulatory structure was inadequate, and coming from the governor of the Bank of England that’s as damming as it could be."

The regulation of the financial system is again racing up the political agenda as banks on both sides of the Atlantic are poised to hand out billions of pounds in bonuses at the end of the year.

Mr King told Scottish business leaders yesterday that it was insufficient to expect that in the future tighter regulations alone would be enough to prevent banks from generating financial crises.

Governments in the UK and US have tacitly ruled out splitting up the biggest banks and opted instead to scrutinise them more actively.

In a speech in Edinburgh, the Governor said "It is in our collective interest to reduce the dependence of so many households and businesses on so few institutions that engage in so many risky activities. The case for a serious review of how the banking industry is structured and regulated is strong."

George Osborne, the shadow chancellor, described Mr King's analysis as "powerful and persuasive”.

Volcker on separating banking and proprietary trading

He wants the nation’s banks to be prohibited from owning and trading risky securities, the very practice that got the biggest ones into deep trouble in 2008. And the administration is saying no, it will not separate commercial banking from investment operations.

“I am not pounding the desk all the time, but I am making my point,” Mr. Volcker said in one of his infrequent on-the-record interviews. “I have talked to some senators who asked me to talk to them, and if people want to talk to me, I talk to them. But I am not going around knocking on doors.”

Still, he does head the president’s Economic Recovery Advisory Board, which makes him the administration’s most prominent outside economic adviser. As Fed chairman from 1979 to 1987, he helped the country weather more than one crisis. And in the campaign last year, he appeared occasionally with Mr. Obama, including a town hall meeting in Florida last fall. His towering presence (he is 6-foot-8) offered reassurance that the candidate’s economic policies, in the midst of a crisis, were trustworthy.

More subtly, Mr. Obama has in Mr. Volcker an adviser perceived as standing apart from Wall Street, and critical of its ways, some administration officials say, while Timothy F. Geithner, the Treasury secretary, and Lawrence H. Summers, chief of the National Economic Council, are seen, rightly or wrongly, as more sympathetic to the concerns of investment bankers.

For all these reasons, Mr. Volcker’s approach to financial regulation cannot be just brushed off — and Mr. Goolsbee, speaking for the administration, is careful not to do so. “We have discussed these issues with Paul Volcker extensively,” he said.

Mr. Volcker’s proposal would roll back the nation’s commercial banks to an earlier era, when they were restricted to commercial banking and prohibited from engaging in risky Wall Street activities.

The Obama team, in contrast, would let the giants survive, but would regulate them extensively, so they could not get themselves and the nation into trouble again. While the administration’s proposal languishes, giants like Goldman Sachs have re-engaged in old trading practices, once again earning big profits and planning big bonuses.

Mr. Volcker argues that regulation by itself will not work. Sooner or later, the giants, in pursuit of profits, will get into trouble. The administration should accept this and shield commercial banking from Wall Street’s wild ways.

“The banks are there to serve the public,” Mr. Volcker said, “and that is what they should concentrate on. These other activities create conflicts of interest. They create risks, and if you try to control the risks with supervision, that just creates friction and difficulties” and ultimately fails.

The only viable solution, in the Volcker view, is to break up the giants. JPMorgan Chase would have to give up the trading operations acquired from Bear Stearns. Bank of America and Merrill Lynch would go back to being separate companies. Goldman Sachs could no longer be a bank holding company. It’s a tall order, and to achieve it Congress would have to enact a modern-day version of the 1933 Glass-Steagall Act, which mandated separation.

Glass-Steagall was watered down over the years and finally revoked in 1999. In the Volcker resurrection, commercial banks would take deposits, manage the nation’s payments system, make standard loans and even trade securities for their customers — just not for themselves. The government, in return, would rescue banks that fail.

On the other side of the wall, investment houses would be free to buy and sell securities for their own accounts, borrowing to leverage these trades and thus multiplying the profits, and the risks.

Being separated from banks, the investment houses would no longer have access to federally insured deposits to finance this trading. If one failed, the government would supervise an orderly liquidation. None would be too big to fail — a designation that could arise for a handful of institutions under the administration’s proposal.

“People say I’m old-fashioned and banks can no longer be separated from nonbank activity,” Mr. Volcker said, acknowledging criticism that he is nostalgic for an earlier era. “That argument,” he added ruefully, “brought us to where we are today.”

He may not be alone in his proposal, but he is nearly so. Most economists and policy makers argue that a global economy requires that America have big financial institutions to compete against others in Europe and Asia. An administration spokesman says the Obama proposal for reform would result in financial institutions that could fail without damaging the system.

Still, a handful side with Mr. Volcker, among them Joseph E. Stiglitz, a Nobel laureate in economics at Columbia and a former official in the Clinton administration. “We would have a cleaner, safer banking system,” Mr. Stiglitz said, adding that while he endorses Mr. Volcker’s proposal, the former Fed chairman is nevertheless embarked on a quixotic journey.

Volcker redux

There has been a loss of perspective with regard to the financial sector led by the Anglo-American banking interests.

This will have to change before there can be a sustainable economic recovery. This will be difficult to accomplish, because there exists a fusion of corporate and government desires to control the distribution of wealth and power that is opposed to any significant reforms.

"A certain type of person strives to become a master over all, and to extend his force, his will to power, and to subdue all that resists it. But he encounters the power of others, and comes to an arrangement, a union, with those that are like him: thus they work together to serve the will to power. And the process goes on." Friedrich Nietzsche, The Will to Power Until then the world will experience a series of asset bubbles and increasing disparity in wealth and political power between the productive and administrative sectors of the economy ad society. This will continue until it becomes unsustainable, and unstable. And then it will change, as it always does.

UK Telegraph

Ex-Fed chief Paul Volcker's 'telling' words on derivatives industry By Louise Armitstead 9:41PM GMT 08 Dec 2009

The former US Federal Reserve chairman told an audience that included some of the world's most senior financiers that their industry's "single most important" contribution in the last 25 years has been automatic telling machines, which he said had at least proved "useful".

Echoing FSA chairman Lord Turner's comments that banks are "socially useless", Mr Volcker told delegates who had been discussing how to rebuild the financial system to "wake up". He said credit default swaps and collateralised debt obligations had taken the economy "right to the brink of disaster" and added that the economy had grown at "greater rates of speed" during the 1960s without such products.

When one stunned audience member suggested that Mr Volcker did not really mean bond markets and securitisations had contributed "nothing at all", he replied: "You can innovate as much as you like, but do it within a structure that doesn't put the whole economy at risk."

He said he agreed with George Soros, the billionaire investor, who said investment banks must stick to serving clients and "proprietary trading should be pushed out of investment banks and to hedge funds where they belong".

Mr Volcker argued that banks did have a vital role to play as holders of deposits and providers of credit. This importance meant it was correct that they should be "regulated on one side and protected on the other". He said riskier financial activities should be limited to hedge funds to whom society could say: "If you fail, fail. I'm not going to help you. Your stock is gone, creditors are at risk, but no one else is affected."

Times UK

‘Wake up, gentlemen’, world’s top bankers warned by former Fed chairman Volcker By Patrick Hosking and Suzy Jagger December 9, 2009

One of the most senior figures in the financial world surprised a conference of high-level bankers yesterday when he criticised them for failing to grasp the magnitude of the financial crisis and belittled their suggested reforms.

Paul Volcker, a former chairman of the US Federal Reserve, berated the bankers for their failure to acknowledge a problem with personal rewards and questioned their claims for financial innovation.

On the subject of pay, he said: “Has there been one financial leader to say this is really excessive? Wake up, gentlemen. Your response, I can only say, has been inadequate.”

As bankers demanded that new regulation should not stifle innovation, a clearly irritated Mr Volcker said that the biggest innovation in the industry over the past 20 years had been the cash machine. He went on to attack the rise of complex products such as credit default swaps (CDS).

“I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence,” said Mr Volcker, who ran the Fed from 1979 to 1987 and is now chairman of President Obama’s Economic Recovery Advisory Board.

He said that financial services in the United States had increased its share of value added from 2 per cent to 6.5 per cent, but he asked: “Is that a reflection of your financial innovation, or just a reflection of what you’re paid?”

Mr Volcker’s broadside punctured a slightly cosy atmosphere among bankers and regulators, assembled in a Sussex country house hotel to consider reform measures, at the Future of Finance Initiative, a conference organised by The Wall Street Journal.

Another chilling contribution came from Sir Deryck Maughan, a partner in Kohlberg Kravis Roberts, the private equity firm, who in the 1990s was head of Salomon Brothers, the investment bank.

He warned delegates that many of the flawed mathematical techniques that underpinned banks’ risk management approaches were still being used, saying that the industry had not “faced up to the intellectual failure of risk management systems, which are still hardwired into many banks and many trading floors”.

Sir Deryck also questioned whether it was right that taxpayers should continue to underwrite many of those risks: “There’s something wrong about large proprietary risks being taken at the risk of taxpayers. The asymmetry will not hold. I’m not sure we’ve thought about that.”

Earlier Baroness Vadera, adviser to the G20 — and an adviser to Gordon Brown during the banking crisis — had warned the world’s most senior bankers that continental lenders had yet to acknowledge the scale of their losses and bad debts. She said: “It’s not the UK banks that have to come clean, but some of the continental banks still have issues.”

She added that, contrary to City assumptions, the supposedly hardline French and German governments were more relaxed about leverage and liquidity constraints than Britain and America.

The former UBS banker said that she continued to have nightmares about how close the British banking system came to collapse last year.

She also warned bankers that the G20 process was “like herding cats” and that one of the main problems with the group of the world’s wealthiest nations was that they did not want to give up national sovereignty and co-ordinate their behaviour.

Meanwhile, George Soros argued that CDS should be banned. The billionaire investor likened the widely traded securities to buying life assurance and then giving someone a licence to shoot the insured person.

“They really are a toxic market,” he said. “Credit default swaps give you a chance to bear-raid bonds. And bear raids certainly can work."

US and Japanese proposals for narrow banks

"The purpose of this paper is to examine narrow banking proposals.

First, we survey the narrow banking proposals presented in the United States and Japan, and categorize them by means of two standards:

  1. whether safe assets that a narrow bank is allowed to hold are limited to short-term assets,
  2. whether a narrow bank is allowed to engage in lending activity.

Second, we examine the feasibility of each proposal for the purpose of achieving the stability of the financial system, making use of two theoretical models: Wallace (1996) and Kashyap, Rajan, and Stein (1998).

Finally, we conclude that a desirable narrow bank is one that carries out both deposit-taking and lending activities, though restrictively, and is allowed to invest in short-term safe assets.

Deutsche Bank's Ackermann's rebuttal on narrow banking

The thin, grey line

We’ve all heard of the “Thin Blue Line.” It suggests a thin line of policemen in blue uniforms is all that stands between civilized society and the chaos of predators descending upon us. It is also a term used to express a sense of “brotherhood” that exists between police officers.

There are other lines… thin lines that stand between society and other forms of chaos. I remember a movie about West Point cadets that referred to the military as The Thin Grey Line. There is, however, another Thin Grey Line –in one of the places you would probably least expect it. You will find it in America’s independently owned commercial banks. Our small-enough-to-succeed commercial banks may be all that stand between the American people and an international body set to take the place of the currently ineffective regulatory agencies responsible for overseeing America’s financial services industry.

According to the Federal Reserve Bank of St. Louis, as of June 30, 2009 there were 6,898 commercial banks in the United States. That sounds like a lot – unless, like me, you were a banker in the 1970s and 80s. As of June 30, 1984, for example, there were 14,369 commercial banks. By 1994, that number had been pared down to 10,623. In other words, it doesn’t take a mathematical genius to determine our independent banks have been drastically reduced by number – over half of the commercial banks doing business in 1984 have either been absorbed by bigger banks, or are otherwise out of business.

Who – or, what – might want the number of independent American commercial banks to be reduced by such a substantial number?

According to statistical data provided online by Canadian bank officials, as of February 2009, there are 21 domestic commercial banks in Canada. Additionally, there are 25 foreign- owned commercial banks. The foreign-owned banks include familiar names like Amex Bank of Canada, Bank of America Canada (in voluntary liquidation), Bank of China, Bank of East Asia, (The) Bank of Tokyo-Mitsubishi UFJ, Bank One Canada (in voluntary liquidation), BNP Paribas, United Overseas Bank (UOB Singapore), and Citibank Canada, among others.

America’s neighbor to the North once had over 900 caisses populaires (similar to credit unions and mostly in Quebec). By 2007 consolidation reduced this number to 525 credit unions and caisses populaires outside of Quebec. In essence, Canada (including Quebec) has about 1,000 financial institutions that require regulatory control. Of that group, only 21 are domestically-owned commercial banks.

Before nationalized health care can be successfully implemented, the financial sector must first be compact and easy to control.

Why are Canada’s numbers important? First, because these numbers explain why it has been so much easier to bring socialized everything to Canada and why it’s more difficult to do so in the U.S. For example, before nationalized health care can be successfully implemented, the financial sector must first be compact and easy to control. Second, Canada’s statistics compare favorably to Europe’s banking industry. In other words, while America has 6,898 commercial banks which must be regulated – audited by the Office of the Comptroller of the Currency (OCC) or State Banking officers and monitored by the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve System (FRS) – most other nations have far fewer commercial banks that must be regulated and audited than does the U.S.

I have long believed that the independent banking community in this country is one of the best defenses America has against the forced centralization of bank regulatory oversight on an international basis. It’s our Thin Grey Line. Regulatory controls must be in place before the financial services industry can be “internationalized” and the large number of independent commercial banks in America is helping prevent that from happening.

Bank concentration and crisis

Abstract: This paper studies the impact of bank concentration, regulations, and national institutions on the likelihood of suffering a systemic banking crisis. Using data on 79 countries over the period 1980-1997, we find that crises are less likely

  • (i) in more concentrated banking systems,
  • (ii) in countries with fewer regulatory restrictions on bank competition and activities,
  • (iii) in economies with better institutions, i.e., institutions that encourage competition and support private property rights.


  • Safe Bank Central An educational site for resources on safe banks and narrows banks advocating their wider adoption as a partial solution to the global financial crisis

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