Ultimately the “correct solution†to the US’s banking troubles are not going to come from a simple return to narrow banking or a switch to macro-prudential banking either. While macro-prudential banking looks in its early stages to be working in Columbia and Spain, it has no proven success in an advanced economy, and its reliance on data and data analysis is fairly dangerous. While of course new is not always “bad,†when dealing with the American economy I think it is essential to start off with a system that has been proven to work soundly, and then implement smaller reforms on this system to make the system work even better. On the other hand, simply narrow banking (completely separating commercial and investment banks) appears to be pretty restrictive on both the commercial and investment sector and would thus lower potential economic growth. The “too big to fail†proposal, while it has many positive aspects, really seems like an answer to only part of the problem.
The best solution I believe will take aspects from all three, and the banking solution I propose does this to some degree. Narrow banking- when done correctly- has worked very well in the past for the American economy: From post-WWII up through the late 90’s, the US was essentially void of any long (1+ year) recessions, outside of those due to extreme jumps in oil prices (rise in OPEC oil prices in 1973 along with Vietnam spending and also 1981 with jump in oil prices due to the Iranian Revolution). This was while following a strict narrow banking strategy as imposed by the Glass Steagle Act. As a reference, prior to the implementation of narrow banking there were over 10 recessions of 1+ year in the US in the previous 100 years (including a number that lasted over 2 years). With less enforcement of the act in the 1990s and finally the repeal of it in 1999, investment banks quickly began playing the role of commercial banks and taking on deposits, and commercial banks began selling off their deposits as investments. Quickly this led to the worst financial crisis in the US since the Great Depression. However, it is important to remember that while the financial crisis did emerge from the mixing of banking roles, extreme economic growth occurred initially. The best solution should seek to embrace this economic growth while preventing large financial crises that can stagnate it. My proposal plans to follow a “less narrow†form of narrow banking that will be less restrictive on banks, but prevent the devalue of assets from bringing down the entire financial institution.
- The first reform I think that needs to be implemented is a simple restriction on the size financial institutions are allowed to grow to relative to the whole system. When one bank gets too intertwined in the affairs of all other banks and is essentially “too large to fail,†this can be a huge problem and have market-wide implications. Restrictions on the percentage of market assets held by any one financial institution need to be implemented to prevent the dependency of an entire economy on this single institution. Banks will still be able to continue growing, just not at a significantly faster rate than the rest.
- A clear distinction must be made between investment banking and commercial banking, just as with the Glass Steagle Act. Investment banks must be in no case allowed to take on deposits. Commercial banks must be restricted from selling off their deposits as assets, outside of Prime low risk mortgages. Requiring commercial banks to hold onto all but the most risk-free mortgages will act as in the past, as an incentive for them to not let the mortgages default. In my proposed strategy, all assets would fall under 3 “tiers†according to their riskiness. Tier 1 would include low risk highly liquid assets, tier 2 less liquid and more risky assets, and tier 3 the highest risk and least liquid assets. The basics of each tier are outlined in the table below:
Tier 1
MMMFs, Treasury Bills, Certificates of Deposit, Gov’t Bonds, Euro debt securities
Tier 2
Corporate Bonds, Preference shares
Tier 3
Debentures, Corporate stocks, credit card debt, derivitives, AAA securities (rated by Fed)
- In this proposed model, investment banks would be allowed to invest in all 3 tiers. During times of market efficiency/stability, commercial banks would be limited to tier 1 assets. Close regulation of the financial system (as in macro-prudential banking), would be put into place by the Fed to closely monitor market-wide risk, and based on this risk commercial banks would be permitted to invest in Medium risk (tier 2) assets depending on the financial conditions- during times of recession tier 2 assets will become available for commercial investment, and during booms these assets would close off.
- Additionally, credit requirements would be raised and lowered to accommodate the systemic risk (like macro-prudential calls for), lowering requirements during recessions as incentive to firms and individuals. This would essentially become another job of the fed- assess and change credit requirements and change commercial investment abilities. However, because commercial banks and mortgage companies will have to hold onto their mortgages and other loans, they will keep only giving loans to credit-worthy borrowers, and they themselves will face the problems of creditworthiness rather than the investment banks. Because narrow banking will still be in place, however, even if the data used to analyze risk ends up being incorrect, commercial and investment banking will still be largely separated and so the financial system will remain intact. In this sense, over-reliance on the analytical methods used to measure systemic risk will cease to exist.
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