Narrow-minded

A radical proposal for making finance safer resurfaces

Jun 7th 2014 |

WHEN Franklin Roosevelt took office in 1933, his first order of business was to arrest the banking collapse that was plunging America ever deeper into depression. As part of the plan for doing so, he signed into law the first federal insurance scheme for deposits, reshaping American finance.

Roosevelt did so at the behest of Congress, but had deep reservations. He worried that deposit insurance would “make the United States government liable for the mistakes and errors of individual banks, and put a premium on unsound banking in the future.” He was right to worry. As intended, deposit insurance made banks less prone to runs (depositors trying to withdraw their money before everyone else does). But it also reduced depositors’ incentive to monitor banks’ behaviour. With less market discipline, a heavy-handed system of regulation evolved.

Over time the scale of the government safety net grew, reaching new dimensions during the financial crisis of 2007-08. That did not involve many runs on conventional deposits, but it did feature a flight from short-term investments that had come to resemble bank deposits, such as money-market funds and asset-backed commercial paper. When these “non-bank” creditors began running for the exits, the federal government’s backstop was extended well beyond deposits. In the aftermath of the crisis the authorities imposed even heavier oversight on the financial system. Debate rages about whether these reforms have made finance safer. But few deny that any improvement in soundness has come at the price of hugely intrusive regulation.

Is there an alternative? Back in 1933 a group of economists from the University of Chicago sent Roosevelt’s administration a memo outlining one. The Chicago plan, as it became known, would split banks’ two main functions: taking deposits and making loans. Banks would have to have 100% of their deposits readily available for withdrawals. Lending, with all its risks, would be left to firms financed by private investors who were willing to countenance losses in search of big returns.

Roosevelt opted for deposit insurance, but the Chicago plan’s central idea, dubbed “narrow banking”, has intrigued economists ever since. The latest advocate is John Cochrane of the University of Chicago’s Booth School of Business. In a recent paper he proposes a system of financial regulation modelled on the original Chicago plan, with a few 21st-century bells and whistles.

Any bank or bank-like entity, such as a money-market mutual fund, financing itself with short-term fixed-value liabilities could only invest in short-term debt issued by the Treasury or the Federal Reserve. Banks could still engage in other business—handling payments, issuing credit cards, issuing derivative contracts and so on—but they would be barred from using short-term debt to fund such activities.

Leverage would not be eliminated entirely. Financial institutions would be able to borrow. But to minimise the systemic risks of this debt Mr Cochrane proposes a Pigouvian tax. Such taxes are intended to offset the harm to society of a given activity, most commonly the emission of some form of pollution. In this case the tax would be a levy of several percentage points on outstanding debts to compensate society for the systemic risks they create.

Would it work? A paper published in 2012 by two economists at the IMF concluded that the Chicago plan would result in less pronounced booms and busts. But such a plan raises huge practical questions. The first is implementation: how to get from today’s system of highly indebted banks to one in which they are financed chiefly by equity. Politically, there would be formidable opposition from vested interests. Economically, the transition would require banks to dispose of a vast stock of loans, or raise an equivalent amount of long-term debt and equity.

A second concern is whether a split between narrow banks and wider lending-and-investment firms would actually eliminate runs. If other institutions replace banks in making loans, they could end up creating fragilities of their own. Mutual funds, for example, are financed by shareholders, not creditors; but if such shares are seen as stable and safe, investors will treat them as deposits—and try to withdraw their investment if that safety is threatened. One study found that mutual funds holding illiquid assets were more likely to suffer investor redemptions because of bad performance than were funds holding liquid assets.

From runs to fire sales

“Collective attempts at liquidation to meet withdrawal requests would lead to ruinous fire sales,” write Stephen Cecchetti of Brandeis University and Kim Schoenholtz of New York University. “After this happened even once, people would simply flock to the narrow banks, and there would be no source of lending.” To prevent this, the authors argue, governments would have to intervene to save the “not-so-narrow intermediaries”.

Third, such a system would still need plenty of regulation. For instance, there is the question of how to define Mr Cochrane’s short-term liabilities and hence the scope of his Pigouvian taxes. What types of debt would be covered? One-day, 90-day or one-year debt? What about callable, convertible and floating-rate debt? Would industrial companies pay the tax? What about quasi-financial companies, such as leasing companies? All these decisions would require extensive government meddling, creating opportunities for lobbying and regulatory arbitrage.

There is no guarantee that Mr Cochrane’s plan would be simpler or safer than the current system. But given the growing cost and inefficiency of today’s regulatory regime, the concept of narrow banking surely deserves more serious consideration.

_Sources:

_{“The ‘Chicago Plan’ and New Deal Banking Reform“, by Ronnie Phillips, Jerome Levy Economics Institute of Bard College, 1992}

_{“The Chicago Plan Revisited“, by Jaromir Benes and Michael Kumhof, IMF Working Paper, 2012}

_{“Payoff complementarities and financial fragility: Evidence from mutual fund outflows“, by Qi Chen, Itay Goldstein and Wei Jiang, Journal of Financial Economics, 2010}

_{“Toward a run-free financial system“, by John Cochrane, Chicago Booth School of Business, 2014}

The original article is linked here.

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