Shadow Banks and Narrow Banks

A Money View

One enduring lesson of the crisis is the truth of the old saw “banking is as banking does.” It has never made much intellectual sense to confine attention to a particular class of regulated entities that are called banks, or to track the movements of their assets and liabilities while ignoring the assets and liabilities of entities doing functionally identical business.

If policymakers did so at one time, it was for practical reasons—they were responsible for the things called banks, and had some control over them as well. Non-banks, even if they were functionally identical to banks, were someone else’s problem, and a tough problem too since there were no very evident points of control.

Maybe the solution is simply to outlaw shadow banking? And while we are at it, since banking is as banking does, why not outlaw non-shadow banking as well? In the United States, this line of thinking is called variously narrow banking, 100% banking, or simply ” The Chicago Plan”. (British readers please note, what Mervyn King calls narrow banking is something much broader.)

It turned out, of course, that the someone else was all of us, and a tough problem now confronts us all. The politics are tough to be sure, maybe even tougher than the economics, but the economics are tough enough even without the politics, so let’s focus there.

Henry Simons, in his “Positive Program for Laissez Faire” (1934), explicitly called for “abolition of private deposit banking on the basis of fractional reserves”. Milton Friedman, in his “Monetary and Fiscal Framework for Economic Stability” (1948) imagines a world not only without banks but also without private credit of any sort.

Simons was writing in the midst of the Depression-era collapse of private banking, and in opposition to New Deal measures to prop the system up. Friedman was writing in the midst of war-time conflation of the Treasury with the central bank, which enabled unprecedented expansion of government debt (and money), and repression of private credit.

In a sense the current global financial crisis combines features of both historic periods. We have seen collapse of the non-bank banking system, and we have also seen methods of war finance employed to prop the system up.

Not surprising then that a version of the narrow banking idea has surfaced again, this time from the pen of my colleague Larry Kotlikoff, under the name ” Limited Purpose Banking.” Unlike his predecessors, Kotlikoff doesn’t want to outlaw private credit (and he has serious reservations about the state of public credit!), but like Henry Simons before him he definitely wants to abolish private deposit banking on the basis of fractional reserves.

It is not going to happen, of course, but why not? The political opposition would be enough, but we are putting that aside. The deep economic question is, What is it about the way the actual economy works that stands in the way? What does the money view perspective have to say about narrow banking?

The short answer is that narrow banking would eliminate the banks’ dealer function—no more two-way market at par between bank deposits and cash. Bank deposits would be just cloakroom tickets, with exactly as many tickets as cloaks. The world of money would be severed completely from the world of credit.

From a money view perspective, this is not a world that would work very well. Put another way, there would be powerful incentives in this world for profit-seeking man to rejoin what the hand of the state has put asunder. Such, anyway, is the lesson of history. Indeed, those powerful incentives are the origin of fractional reserve banking, and also of so-called shadow banking.

Now comes Sandra Krieger, head of the Credit and Payments Risk Group at the New York Fed, speaking about ” Reducing the Systemic Risk in Shadow Maturity Transformation”. She doesn’t want to abolish banking, but she definitely wants to draw a line between banks and shadow banks, and to treat them differently.

“We were reminded during the financial crisis of how banks are special—they have access to direct and explicit official credit and liquidity backstops…It is a different story for financial intermediaries without this type of backstop. [During the crisis, the Fed lent freely to both.] Thus, the defining characteristic of the shadow institutions and their obligations—the absence of direct and explicit access to official credit and liquidity—was violated.”

As a student of Bagehot, I understand drawing a line between different kinds of credit, some eligible for discount and others not. I do not understand drawing a line between different kinds of banks, some eligible to take collateral to the discount window and others not, even if it is the same collateral.

The lesson of this crisis, which should be uncontroversial, is that banking is as banking does. The social purpose of central banks is not to safeguard individual (special) banks, but rather the banking system as a whole.

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