This leaves only one workable approach: a return to narrow banking in which the activities banks can engage in are narrowly circumscribed.

TO BE NOTED: From CEPS:

"Paul De Grauwe is Professor of Economics at the University of Leuven and Associate Senior
Fellow at CEPS. This Commentary was previously published in What the G20 should do on
November 15th to fix the financial system, Barry Eichengreen and Richard Baldwin (eds), a
VoxEU.org Publication, November 2008.
CEPS Commentaries offer concise, policy-oriented insights into topical issues in European
affairs. The views expressed are attributable only to the authors in a personal capacity and
not to any institution with which they are associated.
Available for free downloading from the CEPS website (http://www.ceps.eu) 􀁹 © CEPS 2008


Returning to Narrow Banking
CEPS Commentary/14 November 2008
Paul De Grauwe
Bubbles and crashes have been part of financial markets for centuries. Allowing
banks – which inevitably borrow short and lend long – to get deeply involved into
financial markets is a recipe for disaster. The solution is to restrict banks to
traditional, narrow banking with traditional oversight and guarantees while requiring
financial firms involved in financial markets to more closely match the average
maturities of their assets and liabilities.
here can be no doubt that a reform of the international financial system is
necessary to avoid future crises. However, the G20 meeting in Washington on
15 November 2008, should also avoid an agenda that attempts to take on too
many problems. The leaders need to focus on the essential problem – the international
banking crisis and the factors that led to this crisis.
Banks’ inherent instability
It is useful to start from the basics. Banks are in the business of borrowing short and
lending long. In doing so, they provide an essential service to the rest of us, i.e. they
create credit that allows the real economy to grow and expand. This credit-creation
service, however, is based on an inherently fragile system. If the banks’ depositors or
lenders are gripped by collective distrust and everyone decides they want their money
back, bank will go broke; the money is not there since the deposits were invested in
illiquid assets. This is how a liquidity crisis erupts, setting in motion a devilish cycle
of insolvency and new liquidity crises.
Repeal of stability regulation
We learned from the Great Depression that in order to avoid such crises we have to
limit the risk-taking by bankers.
We unlearned this lesson during the 1980s and 1990s when the banking sector was
progressively deregulated giving banks opportunities to seek high-risk investments.
The culmination of this deregulatory movement was the repeal of the Glass-Steagall
Act in 1999 under the Clinton administration. This ended the separation of the
commercial and investment banking activities in the US – a separation that had been
in place since the banking collapse in the 1930s. Repeal of the Glass-Steagall Act
opened the gates for US banks to take on the full panoply of risky assets (securities,
T
derivatives and structured products) either directly on their balance sheets or
indirectly through off-balance sheet conduits.
Similar processes of deregulation occurred elsewhere, in particular in Europe, blurring
the distinction between investment and commercial banks, and in the process creating
‘universal banks’. It now appears that this deregulatory process has sown the seeds of
instability into the banking system.
The critical lack of a firebreak
Financial markets have, for centuries, been gripped by speculative fevers that have led
to bubbles and crashes; bubbles and crashes are an endemic feature of financial
markets. But financial market problems do not automatically affect banks. In the most
recent crisis, bubbles and crashes would not have been a major problem had banks not
been involved so deeply in financial markets. Banking sector deregulation, which
started in the 1980s, is what exposed the banks so catastrophically to the speculative
dynamics inherent in financial markets. Banks’ balance sheets became the mirror
images of bubbles and crashes occurring in the financial markets. An explosive
cocktail of credit and liquidity risks was created that was waiting to explode.
The failed Basel approach
The Basel approach to stabilise the banking system is based on an attempt to model
the risks that universal banks take and to compute the required capital ratios that will
minimise this risk. This approach is unworkable because the risks that matter for
universal banks are ‘tail risks’, i.e. events that are extremely rare but extremely large,
such as the nationalization of AIG or Lehman being allowed to go broke. The cost of
such events cannot be exactly quantified because they are so rare.
The only workable approach to ensuring bank stability
This leaves only one workable approach: a return to narrow banking in which the
activities banks can engage in are narrowly circumscribed. In this approach banks are
excluded from investing in equities, derivatives and complex structured products.
Investment in such products can only be performed by financial institutions,
investment banks, which are forbidden from funding these investments by deposits
(either obtained from the public or from other commercial banks).
In a nutshell, a return to narrow banking could be implemented as follows:
Financial institutions would be forced to choose between the status of a commercial
bank and that of investment bank. Only the former would be allowed to attract
deposits from the public and from other commercial banks and to transform these into
a loan portfolio with a longer maturity (duration). Commercial banks would benefit
from the lender-of-last-resort facility and deposit insurance, and would be subject to
normal bank supervision and regulation.
The financial institutions that do not opt for commercial bank status would have to
ensure that the duration of their liabilities is on average at least as long as the duration
of their assets. This would imply, for example, that they would not be allowed to
finance their illiquid assets by short-term credit lines from commercial banks.
International coordination to avoid a classic, regulatory race-to-the-bottom
A return to narrow banking can only occur if it is embedded in an international
agreement. This is where the G20 comes into the picture.
When only one or a few countries return to narrow banking, the banks of these
countries will face a competitive disadvantage. They will lose market shares to banks
that are less tightly regulated – a result that would provoke forceful lobbying against
the restrictions. In the end, the governments of these countries will yield and the
whole process of deregulation will start again.
A comprehensive international agreement will be necessary to remodel the banking
systems and to separate commercial banks from investment banking activities. This is
what a Bretton Woods II conference should focus on.
Clearly there are other desirable reforms, such as providing better incentive structures
for bank managers and rating agencies, or a better representation of emerging
countries in the IMF. The focus of Bretton Woods II, however, should be to reform
the banking system so that it does not get involved in bubbles and crashes that are
endemic to financial markets.
Additional comment & analysis from CEPS on the financial crisis
CEPS has been at the forefront of conducting policy research and analysis on the global
financial turmoil since it first emerged over a year ago. In addition to the present
commentary, you may visit our website to download all of our recent Commentaries on the
crisis:
“Europe’s Two Priorities for the G20”, Daniel Gros, 14 November 2008
“A call for a European Financial Stability Fund”, Daniel Gros and Stefano Micossi, 28
October 2008
“Restoring Confidence”, Karel Lannoo, 21 October 2008
“A Concerted Approach to Re-start the Interbank Market”, Daniel Gros, 10 October 2008
“Nationalizing banks to jumpstart the banking system”, Paul De Grauwe, 10 October 2008
“Credit Rating Agencies: Scapegoat or free-riders?”, Karel Lannoo, 10 October 2008
“The cost of ‘non-Europe'?”, Daniel Gros and Stefano Micossi, 7 October 2008
“Europe’s banking crisis: A call to action”, Open Letter by ten leading economists, 3 October
2008
“Crisis Management Tools for the Euro Area”, Daniel Gros and Stefano Micossi, 30
September 2008
“‘No recourse’ and ‘put options’: Estimating the ‘fair value’ of US mortgage assets”, Daniel
Gros, 23 September 2008
“The beginning of the endgame…”, Daniel Gros and Stefano Micossi, 18 September 2008
“The twin shocks hitting the eurozone”, Paul De Grauwe, 16 September 2008
“The crisis, one year on”, Karel Lannoo, 8 August 2008
“Cherished myths have fallen victim to economic reality”, Paul De Grauwe; 24 July 2008
“It's high time to create a truly European System of Financial Supervisors”, Karel Lannoo, 27
June 2008
“The US Housing Bust and Soaring Oil Prices: What next for the world economy?”, Daniel
Gros and Cecilia Frale, 5 June 2008
As early as April 2006, with the publication of A world out of balance?, CEPS provided an
analysis of the forthcoming problems by diagnosing a bubble in real estate markets. See A
world out of balance?, Special Report of the CEPS Macroeconomic Policy Group, Daniel
Gros, Thomas Mayer and Angel Ubide, April 2006."