One way to make banks safer? Make them “narrower.”
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One lesson from all the bank failures we’ve seen this year is that the way most banks do business can be pretty risky. Banks take in deposits, which customers can withdraw whenever they want, and banks use those deposits to make long-term loans.
That means banks might not have money on hand when depositors want it — especially if people start demanding their deposits all at once.
There is an alternative approach to banking that, in theory, could help banks avoid these kinds of problems altogether. It’s called narrow banking, and the idea is pretty simple: Banks take in depositors’ money, but instead of lending it out, they hold it.
A narrow bank could just lock your money away in a vault behind the tellers, said Julie Hill, a law professor at the University of Alabama. But more likely, it would find a boring, liquid investment to park it in.
“They could hold it, in theory, at the Federal Reserve,” Hill said. “That’s a lot like holding it in a vault, but [they] could potentially earn some interest on it. Or they could invest it in government Treasurys.”
That means a narrow bank couldn’t fail, since it could always pay back its customers — at least, as long as the U.S. government doesn’t default.
On the other hand, holding on to those assets — instead of lending out the money the bank put into them — is not very profitable.
“If all you’re doing is investing in very, very safe products, it’s hard to generate revenue,” Hill said.
For a lot of U.S. history, banks were actually pretty narrow. Before the Federal Reserve and the Federal Deposit Insurance Corp. came along, banks didn’t have much protection if a bunch of depositors barged in and demanded their money all at once, like they did at the Bailey Bros. Building & Loan in “It’s a Wonderful Life.”
Banks faced a lot of runs back then, according to George Pennacchi, a finance professor at the University of Illinois.
“They had to maintain a good proportion of their assets in very short-term loans and relatively safe securities,” Pennacchi said.
The creation of the FDIC and the Federal Reserve gave banks a backstop, Pennacchi said, so they didn’t have to worry as much about runs. As a result, banks could lengthen the maturity of their loans and make loans that were riskier — and more lucrative. Since then, banks have become a lot less narrow.
“In the conventional commercial banking system, there’s not a whole lot of incentive for banks to operate this way,” Pennacchi said.
Some banks are trying to change that, however. In 2017, James McAndrews founded a company literally called the Narrow Bank. It doesn’t make loans and it doesn’t work with regular retail depositors. Instead, it targets big, institutional clients — like pension funds and large corporations — that have a lot of cash that wouldn’t be covered by the FDIC’s limited guarantee.
“These are the investors that are most flighty, most prone to run,” McAndrews said. “They must run if they wish to keep their funds safe.”
The Narrow Bank would keep their money safe by parking it in an account with the New York Federal Reserve. “TNB would then receive interest on the funds in its account at the Federal Reserve and remit much of this interest to the depositor,” McAndrews said.
The problem is, the New York Federal Reserve hasn’t allowed the Narrow Bank to open an account. As a result, the bank’s been dormant for almost six years.
The New York Fed didn’t comment. But the Federal Reserve’s Board of Governors has said it has concerns about narrow banking.
One of them? By luring deposits away from conventional banks, which make loans with deposits, narrow banks could make business loans harder to get and more expensive.
Businesses would then turn to nonbank lenders, said Frederic Mishkin, a banking professor at Columbia Business School and a former Fed governor.
“And if that’s not regulated well, and there are mistakes made, you could get blowups that could be even more severe,” Mishkin said.
We want banks to make loans, Mishkin said, in large part because they’re pretty good at figuring out which borrowers are creditworthy.
“Part of their business model is that they actually have deposits of the persons they lend to,” he said. “So they can actually get information as to whether that firm is doing well, whether they’re taking on too much risk and so forth, which gives them an inherent advantage in figuring out whether they’re a good credit risk or not.”
Mishkin added that there’s a place for narrow banks — but they’re not guaranteed to prevent the next financial crisis.
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