Thursday, February 19, 2015

Pennacchi on Narrow Banking

I stumbled across this nice article, "Narrow Banking" by George Pennacchi. The first part has a informative capsule history of U.S. banking.

George defines a spectrum of "narrow" banks. For example he includes prime money market funds -- borrow money, promise fixed value instant withdrawal, buy Greek bank commercial paper. But that is "narrower" than traditional lending, as the assets are short term and usually marketable.

Some interesting tidbits:
Prior to the twentieth century, British and American commercial banks lent almost exclusively for short maturities. Primarily, loans financed working capital and provided trade credit for borrowers who were expected to obtain cash for repayment in the near future
... the typical structure of these early banks contrasts with the modern view of banks, according to which the received wisdom is that “[t]he principal function of a bank is that of maturity transformation---coming from the fact that lenders prefer deposits to be of a shorter maturity than borrowers, who typically require loans for longer periods” (Noeth & Sengupta 2011, p.8)....maturity transformation was often considered a violation of prudent banking.

On the nature of assets:
Following the US Civil War, many banks ... invested in commercial paper... With the establishment of the Federal Reserve System in 1913, commercial paper became especially desired because it was eligible collateral for borrowing from the Fed’s Discount Window. According to Foulke (1931), prior to the 1930s, banks and trust companies held more than 99% of commercial paper....In contrast, banks today hold very little commercial paper
so "bank" then = "prime money market fund" today -- but, after 1913, with discount window liquidity support. Some disintermediation makes a lot of sense. In 1830, you could not hope to sell commerical paper in 10 milliseconds on an electronic exchange, so the "liquidity creation" by banks was more necessary.  The struggles the SEC is having with prime funds today has deep roots.

Credit lines:
One credit service of banks that is ubiquitous today but was completely absent from banks in the nineteenth and early-twentieth centuries was the loan commitment. In recent years, more than 70% of business lending was from loan-commitment drawdowns.
This was an especially interesting issue in the crisis. Chari,  Christiano, and Kehoe noticed bank lending going up in fall 2008. Lending freeze, what lending freeze?  Scharfstein and Ivashina argued increased lending was mostly companies grabbing cash promised under existing lines of credit.
Prior to the 1930s, banks often had long-term relationships with particular borrowers: Banks would lend repeatedly for short terms to the same borrower....During the financial panic period of 1857--1858, the [Black River] Bank’s number of borrowers declined by nearly 75%,..early banks made virtually no formal loan commitments.
so rolling over loans without commitment is a way to preserve the option not to lend in a crisis. Perhaps Fed liquidity support is what changed rolling over to promising to do so.

Narrow deposit creation and the viability of equity-backed banking:
...[the] Louisiana Banking Act of 1842. ...required a bank to hold specie (gold) and bills of exchange and promissory notes maturing in 90 days or less in amounts at least equal to its deposits and notes issued. Moreover, the ratio of specie to the total of deposits plus notes had to be at least one-third. The bank could make loans with maturities greater than 90 days, such as mortgages, and hold real estate and other fixed assets but they must be funded with equity capital, not deposits or notes.
Hammond (1957, p.683) states, “The available evidence is that the system operated with distinguished success…Although the banks of New Orleans were well known throughout the country for their strength and integrity, the law governing them was not generally emulated.” Sumner (1896, pp. 387, 389) is more enthusiastic, calling the act “the most remarkable law to regulate banks, which was produced in this period, in any State…"
We seem doomed to constantly reinvent the steam engine, then to forget how it worked.
In summary, prior to the early-twentieth century, many US banks functioned similarly to narrow banks by holding primarily short-maturity assets to match their short maturity liabilities. Despite the several episodes of banking panics, it may be argued that panics occurred primarily at banks that deviated from the narrow-banking ideal. 
A new kind of moral hazard:
A more important response to the 1907 panic was the establishment in 1913 of a government lender of last resort and central bank in the form of the Federal Reserve System. Access to the Fed’s Discount Window made it less costly for banks to hold longer-term and more illiquid loans. Indeed, Friedman & Schwartz (1963) argue that the Fed’s existence changed banks’ behavior in ways that led to more bank failures during the early 1930s. Banks shifted to higher credit-risk loans and felt less need to lend to each other during times of stress because that was now considered the Fed’s responsibility (which the Fed failed to perform adequately). capital-asset ratios were trending downward since the 1840s (when they were over 50%), but the decline accelerated following the founding of the Fed and the FDIC. The capital ratio then stabilized in the range of 6%–8% starting in the early 1940s
and half of that at the start of the financial crisis in 2007.
As with other proposed bank reforms, recommendations for narrow banks appear most frequently following major financial crises. With the exception of the Louisiana Banking Act of 1842, and possibly the U.S. Postal Savings System, proposals involving narrow banks have not been implemented.
Well, not yet!

The rest of the paper has a nice summary of narrow banking proposals, and theoretical analysis.


  1. Wow! And back then, mortgages were callable. Talk about short duration lending.

    1. Mortgages are still callable.... at least by the mortgagor... did they use to be callable by the lender?

      For most of US history, mortgages were ~5 year terms with a balloon payment. If credit was tight at the time your loan came due, you might not be able to roll over the loan and lose the farm.

    2. Many mortgage contracts in the 19th and early 20th centuries included clauses allowing the lender to give notice to the borrower demanding payment in full within a set period of time - even if the borrower was not in default.

  2. Narrow banking is an old idea, and continued advocacy seems to ignore secular trends in interest rates. We are now talking about ways to break through the zero lower-bound, which tells me that there isn't enough high-quality government debt in the world to apply this idea on the scale that you want.

    If the goal is to prevent systemic crises, we can do that while backing deposits with a wider class of assets. In his lectures on money, Perry Mehrling uses the abstraction of matched-book securities dealers as the paradigm for modern banking. He says that in principle, banks can have matched books by using derivatives. In practice, previously Absalon commented here that AIG went bust trying to insure the banks.

    If we start from a blank slate, the banking sector can have matched books by design if we change the nature of the bank deposit so that it is indexed to the performance of bank assets in the region where the bank operates. These deposits would be shares in the region, but without the liquidity problems of residuals claims on individual banks (which you would like to be source of funds for loans). We do need a system based on matched books, but there is no need to confine ourselves to the special case of narrow banking + equity-based lending, which cannot supply us with current accounts in the amounts that we need.

  3. You write: ""bank" then = "prime money market fund" today"

    The difference is that a money market fund claim is an equity stake, because the mutual fund is not contractually obliged to pay back your principal, but the bank claim back then was a debt contract, where the bank was obliged to pay the deposit back at par.

    Of course, the underlying claim in a narrow banking proposal is that we can do away with bank-issued money (claims on banks payable at par) and replace that form of money with government-issued money. This was being debated even in the 1930s.

  4. There should be two types of narrow bank accounts. One type should be a pure bailment, where the banks hold on to your cash for you, keep it in a vault, and merely provide electronic payment services. This would be 100% reserve banking, and the banks would charge a fee for their services (deposit insurance is unnecessary since the bank can't lend out or do anything with your money).

    The second type of account would be like what you describe, where the bank can invest your money into mutual funds or money market funds. You would need some form of deposit insurance on this. However, depositors should not be able to write checks on these accounts as a substitute for cash---checks on these accounts should be a more illiquid financial instrument. It should be the same as writing a check on your money market or mutual fund account.This scheme would do away with the money multiplier

    1. There is no need to keep cash in a vault any more. Cash is just government debt. The bank can hold short-term treasuries instead, as electronic book entries (much safer than paper in safes), and then pay interest on your deposits.

  5. Fascinating post. I think a rock-solid financial system is necessary and doable. What is blocking such a system? The Pelican State ideas are fascinating.

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  7. I’m not sure the historical record is quite as simple as Pennacchi (or you) seem to imply. Narrow banking or not - bank panics were pretty common in the 1800s. And banks in the 19th c were in the business of maturity transformation, even if different in form and maturity from today. At least in Britain, or so it seems from reading the first few chapters of Lombard Street. Bagehot focuses almost entirely on what looks like maturity transformation - the short maturity of liabilities (demand deposits) relative to the longer-term assets held by banks and bill brokers. (Even if bills were 60 or 90 days - and I’m not convinced that was all of their liabilities - that was an infinity when a panic struck.) Here’s Bagehot:

    Of the many millions [of pounds] in Lombard street, infinitely the greater proportion is held by bankers or others on short notice or on demand; that is to say, the owners could ask for it all any day they please: in a panic some of them do ask for some of it. If any large fraction of that money really was demanded, our banking system and our industrial system too would be in great danger.

    there is no country at present, and there never was any country before, in which the ratio of the cash reserve to the bank deposits was so small as it is now in England. So far from our being able to rely on the proportional magnitude of our cash in hand, the amount of that cash is so exceedingly small that a bystander almost trembles when he compares its minuteness with the immensity of the credit which rests upon it.

    Three times since 1844 the Banking Department [of the Bank of England] has received assistance, and would have failed without it. In 1825, the entire concern almost suspended payment; in 1797, it actually did so. But still there is a faith in the Bank, contrary to experience, and despising evidence. No doubt in every one of these years the condition of the Bank, divided or undivided, was in a certain sense most sound; it could ultimately have paid all its creditors all it owed, and returned to its shareholders all their own capital. But ultimate payment is not what the creditors of a bank want; they want present, not postponed, payment; they want to be repaid according to agreement; the contract was that they should be paid on demand, and if they are not paid on demand they may be ruined. And that instant payment, in the years I speak of, the Bank of England certainly could not have made.

    Excerpts From: Bagehot, Walter. “Lombard Street : a description of the money market.”

    Further, I’m not sure I fully agree with Pennacchi’s thoughts about the changes in bank behavior due to the Fed after 1913 - that the existence of the Fed moved banks away from “narrow banking". More specifically Pennacchi's implication that Friedman and Schwartz (1963) argue for this. (“Banks shifted to higher credit-risk loans and felt less need to lend to each other during times of stress because that was now considered the Fed’s responsibility.”) The 2nd part of his phrase yes, but I don’t remember Friedman and Schwarz arguing that the Fed’s existence pushed banks towards higher credit-risk loans or that that had an effect on banking panics. Maybe banks did shift - but I thought the thrust of Friedman & Schwartz’s argument was on banks' response to panic. First, they contrasted NY banks' behavior in 1893-94 and 1907 (when NY banks banded together and suspended convertibility of deposits to cash in response to a crises provoked outside the banking sector) versus the 1930s (when banks felt deposit drains were the Fed’s responsibility - which it was supposed to be). Friedman and Schwartz did indeed point NY banks' failure to lend to and support Bank of United States in 1932 or 1933 - letting it fail. But F&S did not argue this was related to low credit quality of Bank of United States's assets - rather the contrary - if I remember correctly they point out that all liabilities were ultimately repaid.

  8. You argue here that bank runs/panics can be cured by narrow banking, but this has been tried before. During the great depression with the "Chicago Plan" Moving to almost 100% reserve rate didn't lower the percentage of full withdrawals, it just lowered the number of clients storing their money in the bank. By narrowing the banking regulations, you diminish the incentive to use the bank in the first place. People will be less likely to run on their money, but even less likely to keep their account open when they have to start paying fees in the stead of receiving interest.

  9. You argue here that bank runs/panics can be cured by narrow banking, but this has been tried before. During the great depression with the "Chicago Plan" Moving to almost 100% reserve rate didn't lower the percentage of full withdrawals, it just lowered the number of clients storing their money in the bank. By narrowing the banking regulations, you diminish the incentive to use the bank in the first place. People will be less likely to run on their money, but even less likely to keep their account open when they have to start paying fees in the stead of receiving interest.


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