Randall J. Pozdena

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 91-39, November 8, 1991
The False Hope of the Narrow Bank
Current proposals to reform the banking system
are intended to limit the cost ofthe safety net,
while enhancing the stability and competitive-
ness of U.S. banks. One proposal that has received
a significant following is to limit the safety net to
"narrow" banks. These banks could offer insured
deposits, but would be restricted sharply in their
asset powers. Risky assets wQuld be held by other
banks not enjoying deposit guarantees. The re-
sult is supposed to be a banking system that is
both safe and stable.
This Letter highlights some of the flaws in the
concept of deposits backed only by safe assets.
!n particular, I argue that the issuance of deposits
backed by risky assets has important economic
justification. 1\t1aking banks "nariOW" thus risks
handicapping the flow of funds to commerce.
Just as importantly, however, the narrow banking
notion does not solve the problem of banking
system stability.
The narrow bank
Although differing in their details, all the narrow
banking proposals involve partitioning the bank-
ing system into "safe" banks for deposits, and
"risky" banks whose liabilities would enjoy no
insurance. The safety of deposits in the narrow
banks would be guaranteed by a system ofessen-
tially full deposit coverage. In turn, the integrity
ofthe insurance fund would be preserved by per-
mitting insured banks only to hold "safe" assets.
Some proponents of narrow banking define
"safe" assets to include only government and
agency securities. Others, such as Bryan (1991)
would extend the range of assets permitted in the
insured "core" banks to others that "have proven
over time to be relatively safe," including home
mortgages and accounts receiving financing.
Implicit in all of the proposals, however, is the
notion that the use of demand debt to finance
risky assets can be restricted without great harm.
Banking and information asymmetry
To see why this reasoning might be flawed, it is
first necessary to characterize the informational
environment in which banks exist, and which
justifies their existence as intermediaries. (It is
easiest to introduce the necessary arguments by
assuming initially that deposit insurance does
not exist.)
Financial intermediaries (including banks) exist
in a world in which the information needed to
assess financial risks is not perfect, or evenly dis-
tributed. In particular, the businesses that want to
borrow to finance new projects tend to have bet-
ter information about the true prospects ofthe
projects than do the (outside) lenders. Similarly,
bank management has better information about
the quality of its investments than do outside
depositors. Without special contracts, the unin-
formed parties would be reluctant to provide
credit for fear of being exploited by the better
informed parties. Depositors would not lend
their funds to banks, and banks would not lend
their funds to firms.
Contractual solutions have evolved to address
this dilemma. Bank loan agreements incorporate
features to permit banks to monitor the activities
of the borrower, and to take actions, if necessary,
to protect the bank's interests. Analogously, de-
positors need to be offered special contractual
protection to be induced to place their funds in
a bank. Depositors are uninformed relative to
bank management, and most also do not have
the resources to be good monitors; in addition,
the bank can be expected to worry less about its
reputation with individual depositors than with
larger investors. Thus, depositors need to be
offered a particularly potent and economical
means of avoiding exploitation by the bank.
Demand debt is just such an instrument. By re-
quiring banks to make good on deposits at fixed
nominal value on demand, and with low transac-
tion costs, holders of demand deposits can easily
withdraw their investment in a poorly managed
bank. In this way, they exert discipline on bank
behavior.
Why combine deposits and risky loans?
Demand debt thus is a concession by bank man-
agement to the needs ofdepositors for control. AtFRBSF
first glance, however, it seems to be a very costly
concession. In the absence of deposit insurance,
demand debt exposes banks to runs, and banks
must invest partlv in liquid assets to meet the un-
certain withdra~als of depositors. Since a bank's
greatest returns are from assets that exploit its
monitoring expertise (assets that are, by defini-
tion, illiquid), having to accommodate the possi-
bilityof runs thus is costly to the bank.
But would other forms of liabilities be cheaper?
For example,banks alternatively could raise
funds by issuing equity shares (similar to a
money market mutual fund). These claims do not
impose liquidityrestrictidns on the bank's asset
portfolio. However, the work of Myers and Majluf
(1984) suggests that equity would be even more
costly than debt in a setting of asymmetric infor-
mationabout the value of the bank's assets. This
is because uninformed eauitv holders will be re"
luctant to agree to the new i~suance of equity;
since they are uninformed about the quality of
the assetsto be acquired, they cannot be certain
that the new equity issuance is in their interest
(rather than being a dilution of their claims). This
can cause new issuance of equity shares to de-
press share values, making equity shares a costly
way of financing new assets.
Issuing long-termdebt is another means of avoid-
ing the liquidity cost of demand debt. But it, too,
imposes additional costs in an environment of
asymmetric information. Specifically, exercising
control via long-term debt involves longer delays
and greater transactions costs for depositors than
would be incurred with demand debt, making it
a less effective means of exerting influence.
Thus, the issuance of demand debt by intermedi-
aries holding risky assets is not serendipitous. It
occurs precisely because bank assets are of un-
certain value, and bankers are better informed
than depositors. Therefore, as long as there is a
significant group of informationally handicapped
investors and risky projects to undertake, inter-
mediaries investing in these assets will tend to
issue demand deposits. And the existence of
demand deposits will tend to make the banking
system prone to runs.
Banks as money market mutual funds?
Would a system of "safe" banks with the exclu-
sive authority to issue insured deposits resolve
this dilemma? To seethe effects clearly, imagine
the most extreme form of the narrowbank, one
that only holds riskless government securities.
Since riskless securities make information asym-
metry problems moot, narrow banks could issue
demand equity, instead of demand debt. And
they would tend to do so, since it does not pose
any liquidity burdens, and thus is cheaper than
demand debt to offer. In essence, such narrow
banks would be like today's mutual funds.
A banking system based on demand equity
would be very safe. Since equity holders have
pro rata, rather than fixed, claims on the bank,
they would gain nothing by running. Deposit
insurance would be redundant in such a narrow
bank, except perhaps to protect against fraud.
But would "risky" deposit-taking banks cease
to exist? On the contrary: As long as banks with
risky assets must deal with uninformed investors,
they will have to issue demand debt. And, unlike
the "safe;' narrow bank, the risky bank provides
monitoring services that add value to the finan-
cial transaction-value that bankers can share
with depositors in order to attract their needed
funds. Thus, as Jacklin (1987) has shown formally,
the marketplace will prefer the demand debt of
risky banks, even if it is uninsured, to equity
claims on "safe" assets, because ofthe superior,
risk-adjusted returns.
A dilemma
As a consequence, the narrow banks will have
a hard time surviving, despite their "safe" asset
structure, and most deposits will be held in risky
banks. The risk of runs would still exist because
the demand debt of risky banks would still be the
dominant bank liability. Regulators could try, of
course, to "force" the dominance of narrow banks
by forbidding risky banks from issuing demand
deposits. But to do so would exact a clear penal-
ty on the economy, if banks are the intermediary
the market prefers. Thus, narrow banking does
not solve the problem of instability in the bank-
ing system except at great expense to the inter-
mediation of credit.
And it is not even clear that the "safety" of the
narrow banking system comes with particularly
lo\,y social costs. tv10st of the securities that make
up the supply of "safe" assets are themselves
backed by public guarantees, either explicitly
in the case of agency issues, such as mortgage-
backed securities, or implicitly in the case offederal and local government debt, which is
guaranteed by virtue of its claims on the future
taxpaying capability of Americans. Thus, to
promote narrow banking based on these "safe"
securities, rather than deposit insurance, to some
degree involves simply substituting one kind of
taxpayer guarantee for another.
Dealing with instability
If narrow banking is not the answer to the prob-
lem of bank runs and banking instability, what is?
There are two answers to this question, depend-
ing upon whether one believes the public sector
or the private sector is more prone to making
mistakes.
One alternative is to eliminate the safety net al-
together, on the grounds that it is unlikely to be
managed well by the public sector. Proponents
of this approach argue that the concomitant
increased discipline that depositors impose on
banks would contain risk-taking. This increased
discipline necessarily would come at the expense
of an increased risk of runs. Proponents of this
view, however, argue that the costs ofthese runs
are low compared to the costs of a mismanaged
safety net.
The second alternative is simply to manage the
safety net better, by requiring bank capital levels
that are high enough so that the marginal value
of public safety net guarantees is low. This re-
quires raising capital requirements, marking bank
portfolios to market, and immediately reor-
ganizing banks that fail to meet the high capital
requirements. In this way, the incentive to exploit
the safety net is diminished. In a previous Letter,
we discussed the successful application of this
approach by a European banking system that has
broad asset powers (Pozdena 1990).
Conclusion
In any case, narrow banking seems not to be a
solution. The artificial partitioning of bank asset
powers is inconsistent with the underlying eco-
nomics of the business of banking. Imposing
narrow banking would not eliminate the issu-
ance of risky demand debt and the concomitant
dilemma of bank runs, but would handicap
financial intermediation. This is why, from the
earliest known banks in Italy in 1200 A.D. to the
present, risky banks that issued demand debt
dominated those issuing claims on "safe" stores
of value.
RandallJ.Pozdena
Vice President
References
Bryan, L. 1991. "A Blueprint for Financial Recon-
struction:' Harvard Business Review (May-june)
pp.73-86.
Jacklin, c. 1987. "Demand Equity and Deposit Insur-
ance:' Graduate School of Business, Stanford
University. Research Paper No. 1062, (rev. April
1990).
Myers,S., and N. Majluf. 1984. "Corporate Financing
and Investment Decisions When Firms Have Infor-
mation that Investors Do Not Have:' Journal of
Financial Economics, 13, pp. 187-221.
Pozdena, R. 1990. "Bank Failures, Danish Style." Fed-
eral Reserve Bank of San Francisco Weekly Letter
(August 3).
Opinions expressed in this newsletter do not necessarily refled the views of the management of the Federal Reserve Bank of
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Index to Recent Issues of FRBSF Weekly Letter
DATE NUMBER TITLE AUTHOR
4/26 (91-17) Record Earnings, But... Zimmerman
5/3 (91-18) The Credit Crunch and The Real Bills Doctrine Walsh
5/10 (91-19) Changing the $100,000 Deposit Insurance Limit Levonian/Cheng
5/17 (91-20) Recession and the West Cromwell
5/24 (91-21 ) Financial Constraints and Bank Credit Furlong
5/31 (91-22) Ending Inflation judd/Motley
6/7 (91-23) Using Consumption to Forecast Income Trehan
6/14 91-24 Free Trade with Mexico? Moreno
7/5 91-25 Is the Prime Rate Too High? Furlong
7/19 91-26 Consumer Confidence and the Outlook for Consumer Spending Throop
7/26 91-27 Real Estate Loan Problems in the West Zimmerman
8/16 91-28 Aerospace Downturn Sherwood-Call
8/30 91-29 Public Preferences and Inflation Walsh
9/6 91-30 Bank Branching and Portfolio Diversification Laderman/Schmidt!
Zimmerman
9/13 91-31 The Gulf War and the U.S. Economy Throop
9/20 91-32 The Negative Effects of Lender Liability Hermalin
9/27 91-33 M2 and the Business Cycle Furlong/judd
10/4 91-34 International Output Comparisons Glick
10/11 91-35 Is Banking Really Prone to Panics? Pozdena
10/18 91-36 Deposit Insurance: Recapitalize or Reform? Levonian
10/25 91-37 Earnings Plummet at Western Banks Zimmerman
11/1 91-38 Bank Stock Risk and Return Neuberger
The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.

A Blueprint for Financial Reconstruction:' Harvard Business Review (May-june)

Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have:'

Demand Equity and Deposit Insurance:'

The false hope of the narrow bank

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The false hope of the narrow bank

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