How narrow should a narrow bank be?

TO BE NOTED: Against Narrow Banking: From Financial World:

"Past imperfect
We cannot, and should not, turn back the clock to the era of ‘narrow banking’, says Vince Heaney. Too much has changed

In turbulent times it is tempting to hark back to supposedly halcyon days. This tendency is currently manifested in calls for a return to an old-fashioned banking system; one in which commercial and investment activities are again separated, as in the US after the introduction of the Glass-Steagall Act in 1933.

Advocates of “narrow banking”, however, risk overlooking two points. First, you cannot turn the clock back. By the time the Glass-Steagall Act was repealed in 1999 regulation was merely catching up with the realities of banking. There had been huge growth in cross-border capital flows following the dismantling of capital controls and the demise of the Bretton Woods fixed exchange rate system.

In their strictest form, narrow banks would be even more proscribed in their activities than banks were during the era of bicycle-clipped bank managers such as Captain Mainwaring of Dad’s Army. Retail deposit-taking institutions, which benefited from deposit insurance guarantees, would not make loans. They would simply run the payments system and hold only safe and liquid assets, such as government bonds. In modern capital markets, such draconian restrictions would be very difficult to enforce.

Second, one would not necessarily want to turn back the clock even if one could do so. Deregulation has brought substantial benefits: it has promoted the efficient allocation of capital and supported growth by allowing companies and households easier access to credit.

Clearly, however, efficient capital allocation gave way to speculation as smart bankers, motivated by short-term gain, exploited the opportunities for circumventing a light-touch regulatory system. With taxpayers now footing the bill for the resulting crisis, it is both understandable and desirable that policy-makers want to address the shortcomings of existing regulation. Since banks cannot be relied upon to supervise themselves adequately and draconian measures are not feasible in globalised capital markets, the problem turns on where to draw the boundary between the regulated and unregulated sectors. How narrow should a narrow bank be? Because regulation lowers profitability in the regulated sector, there is an incentive for business to move into the unregulated sector once the boundary is drawn.

A sensible solution should recognise the inevitability of business moving towards the unregulated sector, but reduce the incentive for it to do so. It would clamp down only when an institution’s size and market share posed a threat to the system. At the same time, the framework should increase monitoring of the unregulated sector and impose restrictions by investment activity, rather than type of institution, to improve transparency. Finally, the regulatory grip should tighten during the upswing, not the downturn.

A consensus on the regulatory framework is emerging that incorporates these characteristics. In January, the Group of Thirty, an international body of financiers and academics, published a report entitled Financial Reform: A Framework for Financial Stability. Among the many recommendations, the high-risk proprietary activities of systemically important banks would be restricted by tougher capital requirements and the retention of a larger proportion of the risks on their own balance sheets. This represents a move towards separation of commercial and investment banking but stops short of prohibition. The G30 also addresses the pro-cyclical disadvantages of the current Basel 2 arrangements, proposing that not only are capital requirements raised but that institutions hold higher levels of capital when markets are “exuberant”.

Outside the regulated sector, the G30 proposes that larger “private pools of capital that employ substantial borrowed funds”, i.e. hedge funds, should register with a regulator and disclose more information. The report also advocates greater regulation by activity – proposing that over-the-counter securitised structured product and derivatives markets be subject to standards comparable with those for public securities markets.

The G30 is headed by Paul Volcker, former Federal Reserve chairman and adviser to President Barack Obama, and includes Tim Geithner, US Treasury secretary, Jean-Claude Trichet, president of the ECB, and Mervyn King, Bank of England governor. Although not all members were involved in writing the report, G30 insiders have told The Economist that everyone was behind the report in spirit.

This widespread agreement, and the report’s recognition that a global problem requires an international solution, raises the probability that proposals along these lines will form the basis for regulatory change in the G20 countries. No overhaul can hope to predict where the next crisis will arise, but reform will be imposed and, if intelligently designed, can at least avoid repeating the mistakes of the past."