Saturday, June 6, 2009

would go a long way toward creating the kinds of institutions that Henry Simons believed would move us toward the financial good society


N a rrow Banking
R e c o n s i d e re d
The Functional Approach to
Financial Reform
Ronnie J. Phillips

No. 18/1995
Public Policy Brief
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S u m m a ry
Ronnie J. Phillips presents the functional approach to reform of the financial
system. This approach advocates the separation of the depository and
lending functions of banks. As a result of the structural separation of banks’
functions, monetary and credit policy undergo a parallel separation, and government
supervision and regulation of the banking industry is modified. The
policy prescription developed within this approach is narrow banking, the
creation of separate monetary and financial service companies with the elimination
of or substantial reduction in deposit insurance. Phillips asserts that
narrow banking not only meets the safety and soundness goals of bank regulation,
but also maintains an institutional structure that accommodates market
forces and technological innovation.
Phillips reviews the history of government involvement in the payments system.
He traces the notion of backing demand deposits with federal government
securities (a notion that is endorsed by the functional approach) to the
early monetary system of the American colonies and to the National
Banking Acts of 1863 and 1864. These acts guaranteed that the Treasury
would redeem notes issued by national banks and backed by government
bonds at par value. Although the currency was backed by government debt,
it was not until the Emergency Banking Act of 1933 that the means of payment
was backed by federal government debt. Two years later the Banking
Act of 1935 created federal deposit insurance.
The functional approach maintains that insurance dulls the incentives of
depositors to seek a depository institution with sound assets and the incentives
of depository institutions to maintain liquidity and high asset quality.
Opposing this view are those who support fractional reserve banking, in
which commercial banks hold central bank liabilities against their own liabilities.
This approach contends that banks perform a valuable service
through their dual functions of depository and lending activity and that this
system yields efficiency gains because of information symmetries and the
ability to hold minimal cash balances. Supporters of fractional reserve banking
argue for reform through instituting risk-based pricing of deposit insurance,
using subordinated debt to monitor banks’ lending activities, having
depositors pay fees for insurance, and increasing capital requirements.
Narrow banking advocates argue that the microeconomic efficiency benefits
of the fractional reserve banking reforms do not outweigh the macroeconomic
In the fractional reserve system the Federal Reserve is able to encourage
credit restraint more easily than credit growth. In the functional system the
Fed retains a significant role in monetary policy and a modified role in credit
policy. One goal of the functional approach is to mitigate the influence of
monetary policy on the credit market. Therefore, in its system monetary policy
affects only those institutions, known as monetary service companies,
holding liabilities backed by government debt. In other words, monetary
policy is not simultaneously credit policy, as it is today.
The portfolios of monetary service companies offering demand deposits
would be restricted to only “safe” assets. The underlying assumption of the
narrow bank policy is that the primary function of banks is to provide a payment
mechanism. Phillips describes several narrow bank proposals that vary
in their definitions of safe assets. However, as the interpretation of safe assets
broadens, additional safety features are linked to the proposals.
Complementing the monetary service companies are financial service companies,
where savings are channeled to investors. Within this financial
structure, financial holding companies may own both types of service
companies, but the assets of the narrow bank remain separate from other
financial units of the holding company. Establishing separate monetary and
financial service companies enhances the safety of the payments system,
improves the ability of the Fed to control monetary aggregates, reduces government
regulation of banks, accommodates the growth of mutual funds, and
eliminates or significantly reduces deposit insurance.
Phillips discusses a number of issues raised by critics of narrow banking: the
availability of safe assets and the corresponding maturities of these assets; the
availability and cost of funds, especially for small businesses and consumers;
access to the payments system; the shrinkage of the size of the banking system;
the potential difficulty with overdrafts; foreign banking operations; and
the political feasibility of the functional approach.
Phillips recommends the adoption of two specific financial system reform
proposals. First, he endorses the creation of monetary service companies that
would serve strictly a payments function and would hold only safe assets, as
prescribed by Robert E. Litan and James L. Pierce. Second, he recommends
the proposal of James R. Barth and R. Dan Brumbaugh, Jr., that the federal
government establish a mutual fund that holds only government securities as
Dimitri B. Papadimitriou..............................7
The Functional Approach to
Financial Reform
Ronnie J. Phillips..........................................9
About the Author....................................49
C o n t e n t s
Ronnie J. Phillips, a research associate of
The Jerome Levy Economics Institute of
Bard College and a professor of economics
at Colorado State University, presents an
essay in this Public Policy Brief on the functional
approach to f inancial reform.
Phillips makes a timely contribution to the
debate on financial reform, given the
current climate for reform in Congress, legislative
changes in the financial service
industry during the 1990s, and the Treasury
Department’s mandate to study the financial
service industry of the United States.
The legislative agenda for the financial
service industry is expected to alter the
structure, the competition, and, some
would argue, the stability of the system. In
response to the savings and loan debacle of
the 1980s, Congress passed the Federal
Deposit Insurance Corporation Improvement
Act (FDICIA) in 1991. More
recently, in 1994, we witnessed the passage
of both the Community Development
and Financial Institutions Act and the
Inter state Banking and Branching
P re f a c e
The Jerome Levy Economics Institute of Bard College 7
Narrow Banking Reconsidered
8 Public Policy Brief
Efficiency Act. Other reforms affecting the industry, including the
reform of both the Banking Act of 1933 (the Glass-Steagall Act) and
deposit insurance, are currently under review.
Phillips directly addresses the second matter under review as he presents
the case for adopting narrow banking, the policy prescription of the
functional approach to financial reform. Narrow banking divides the
depository and lending functions of banks; it creates separate monetary
and financial service companies and eliminates or reduces deposit insurance.
Instead, deposits are backed with “safe” assets. According to
Phillips and other proponents, narrow banking weds the safety and
soundness goals of bank regulation with an institutional structure that
accommodates market forces and technological innovation. In essence,
it significantly reduces the problem of the instability within the banking
The Jerome Levy Economics Institute of Bard College has published
several Public Policy Briefs on the topic of financial reform. The Institute
is committed to an ongoing research program, “Reconstituting the
Financial Structure,” under the direction of Professor Hyman P.
Minsky, a Distinguished Scholar of the Institute. This essay by Phillips
contributes to this growing body of research published by the Institute.
Dimitri B. Papadimitriou
Executive Director
January 1995
The Functional
A p p roach to
Financial Reform
I n t r o d u c t i o n
The banking legislation passed during the
New Deal has provided the basic institutional
structure for the financial system in
the United States for six decades. It has been
evident for many years that elements of this
structure are obsolete and require substantial
modification. As the twenty-first century
approaches the financial system appears
archaic, and there are new challenges to the
established system of bank supervision and
regulation (Pollock 1992a). Beginning with
the Depository Institutions Deregulation and
Monetary Control Act of 1980 (DIDMCA)
and continuing through the Federal Deposit
Insurance Corporation Improvement Act of
1991 (FDICIA), federal legislation has
sought to alleviate problems with the financial
system. The 103rd Congress passed the
most important banking legislation since the
reforms of the New Deal: the Interstate
Banking and Branching Act of 1994. The
signing of this act by President Clinton ends
a two-hundred-year-old debate and begins a
The Jerome Levy Economics Institute of Bard College 9
new era of banking in the United States. President Clinton also signed
the Community Development Banking and Financial Institutions Act to
provide funds to assist community financial institutions in improving
lending and banking services to underserved communities.
The passage of both acts is important, and it is a significant accomplishment
of the administration and Congress. Taken together, this legislation
promises a more efficient payments and lending system, while at the same
time providing for improved access to basic banking services for communities,
both urban and rural, that have not had ready access to banking
s e r v i c e s .
The banking legislative agenda is not completed, however, and there are
three issues that Congress must address soon. First is the repeal of the separation
of commercial and investment banking that was legislated in the
Banking Act of 1933, commonly known as Glass-Steagall. Repeal would
allow the creation of universal banks to provide virtually all financial services
in one institution. However, if we allow universal banks, Congress
must address the second issue: the reform of deposit insurance that was
also established by the Banking Act of 1933 and made permanent by the
Banking Act of 1935. This reform must go beyond the important changes
of FDICIA to a reexamination of the “too big to fail” doctrine. The need
for this reexamination emerged as a result of the debacle of the 1980s.
The third issue is the merging of the various bank regulatory agencies—
Federal Reserve, Office of the Comptroller of the Currency (OCC),
Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift
Supervision. Consideration of such a merger will likely entail a debate
over the role of the Federal Reserve System and whether it should, like
the German Bundesbank, focus exclusively on monetary policy, leaving
bank regulation and supervision to an independent agency. These legislative
changes, together with the possibility of increased antitrust activity
as a result of merger and consolidation activity, will fundamentally alter
the structure of the financial system in the United States that has been in
place since the New Deal (DeYoung and Whalen 1994; Nolle 1994).
This Public Policy Brief provides a framework for regulatory reform that
will establish an appropriate balance between market forces and technological
change, which together determine in large part how the financial
Narrow Banking Reconsidered
10 Public Policy Brief
system changes, and the obligation of government regulators to ensure a
safe and efficient financial system.
James L. Pierce, of the University of California at Berkeley, has recently
articulated what he calls the functional approach to deposit insurance and
regulation (Pierce 1991, 1993).1 This approach argues that bank regulation
and supervision can be greatly simplified if viewed not in terms of
the current institutional arrangement of the financial system (the legacy
of the New Deal), but rather in terms of the functions that should be performed
by an efficient financial system. The objective of this Public Policy
B r i e f is to set forth the functional approach and to provide policy recommendations
for reform of the financial system. The functional approach
proposes a change in the role of government in the institutional arrangement
of our financial system, but the policy prescriptions of the approach
have a well-established basis in American history.
As James R. Barth and R. Dan Brumbaugh, Jr., note in the Levy
Institute’s Public Policy Brief No. 8, “The Changing World of Banking:
Setting the Regulatory Agenda” (1993, 11), too often in the past legislation
has been implemented with little attempt to understand whether
“there were fundamental changes in the overall market for financial services
that were affecting or contributing to the problems being addressed
by the enacted legislation and changes in regulation.” The recent concern
about the growth of the derivatives market and the appropriate regulatory
response is but the latest issue that has prompted congressional
concern and could result in legislation.
Barth, formerly chief economist at the Office of Thrift Supervision and
now a professor at Auburn University, and Brumbaugh, an economic
consultant in California, outline the implications for banks and banking
regulation of the changes in market forces and recent legislative initiatives.
They provide a summary of possible scenarios for fundamental
reform that are consistent with the new bank regulatory environment and
the changing financial marketplace. The basic question, they argue, is
what unique and crucial functions do banks perform that merit such great
attention and protection by the federal government. When we recognize
that the two functions that banks perform, deposit taking and lending,
can and are being performed by other institutions, then we must ask why
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 11
we persist in maintaining an outdated regulatory and supervisory structure.
As Pierce (1993, 8) notes, the functional approach emerged in the
mid-1980s as a response to the savings and loan crisis and concerns about
the system of federal deposit insurance.
Narrow banking, a term coined by Robert E. Litan (1987a, 1987b, 1991),
formerly of the Brookings Institution and now a deputy assistant attorney
general for antitrust, has been the policy prescription most closely associated
with the functional approach, though recently the proposal has been
revised and the new depository institutions labeled “monetary service
companies.” This approach has been widely supported because it meets
both the safety and soundness goals of banking regulation and it provides
an institutional structure that can accommodate market forces and technological
Historically, we have relied on banks to serve a dual function in our
economy: to provide a form of money that was more convenient than
currency in making payments and to channel funds from savers to borrowers.
Recent technological changes and financial innovations, such as
mutual funds, have raised basic questions about whether banks can continue
to serve this dual function and remain competitive financial institutions
(Simonson 1994). Federal deposit insurance was enacted to help
provide a safe and stable payments system. However, many of the regulations
used to control bank risk-taking and to make deposit insurance
viable have had undesirable effects on the lending activity of banks.
Fundamental change in the dual role of banks would mean change in the
payments system, in lending to small firms, and in the conduct of monetary
policy by the Federal Reserve (Bacon 1993).
The proponents of the functional approach to financial reform argue that
fundamental change is necessary to restore the health and vitality of a
financial structure that is being eroded by technological advances and
market forces. They identify the necessary institutional change to be the
separation of the payments system function of banks from their role as an
intermediary between borrowers and lenders. This separation is a prerequisite
for a safe payments system and a smoothly functioning credit
Narrow Banking Reconsidered
12 Public Policy Brief
T h i s Public Policy Brief proceeds by first reviewing the history of government’s
role in the financial system in the United States. Next, it outlines
the problems solved and the potential new problems raised by the various
policy proposals that have emerged from the functional approach to
banking reform. The brief concludes with two specific policy proposals.
A Brief History of Government’s Role
in the Payments System
An important lesson from the history of the monetary system in the
United States is that federal government debt has served as a stable backing
for bank-created money. The functional approach to banking reform
would require that the primary form of the means of payment, checks, be
backed with assets of stable value: federal government securities. This
notion has its origins in the monetary system of the American colonies.
In large part because of a shortage of specie, by the 1730s bills of credit
had become the principal currency. These bills were initially issued in
anticipation of future taxes and redeemed in commodity money (gold or
other metal coins) at some point in the future. Such bills of credit were
unlikely to be inflationary because of their fiscal backing (Calomiris
1988). However, political upheavals and financial incentives for the
colonies to violate their commitments led to considerable fluctuation in
the value of these bills.
During the Revolutionary War the Continental Congress issued a fiat
currency, known as “continentals,” beginning in May 1775 on the by
then well-known principle of redemption in anticipation of future taxes.
The depreciation of the continentals generated great mistrust of money
issued by the federal government, but in 1791 the First Bank of the
United States was established through the efforts of Alexander Hamilton
and others. When its twenty-year charter expired, the debate over government-
issued money resumed, but a Second Bank of the United States
was established in 1816.
The First and Second Banks of the United States each had national charters
and issued a national currency backed by gold and government debt.
After the expiration of the charter of the Second Bank of the United
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 13
States in 1836, the country entered what is known as the “free banking”
era. During this period much of the money stock was privately issued
bank notes. Not surprisingly, this created a host of problems. Although
the bank notes were by law redeemable in gold or silver at the issuing
bank (and there were heavy penalties for a bank’s failure to redeem
them), there were problems associated with redeeming a bank note at par
value outside of a small geographic region. In 1835 and in 1836 Congress
considered bills to impose reserve requirements on the banks that held
the federal government’s funds, but these bills were tabled (Timberlake
1965, 97). However, state banking laws did require reserves in “safe”
assets. The New York State free banking law, passed in 1838, required
that “the state Comptroller of the Currency was to issue bank notes to
promoters of a bank only after they had deposited with the Comptroller
an equal dollar amount of bonds of the United States, of the State of New
York, or of certain other states approved by the Comptroller” (Robertson
1968, 23). The Louisiana Bank Act of 1842 required that deposits and
bank notes be backed one-third by specie and two-thirds by short-term,
high-quality assets (Timberlake 1965, 98; Pollock 1992a). By the time of
the Civil War about half the states had free banking laws modeled on
New York’s law (Robertson 1968, 23).
Because of the high social and private costs of nonpar clearance, by the
1860s proposals for a government-issued currency reappeared.3 Instead of
a single national bank, as had been previously established, the National
Banking Acts of 1863 and 1864 established a national banking system
and a national currency. The national banks could issue bank notes, but
were required to hold $111.11 in government bonds for each $100 of
bank notes issued. The national bank notes, though not legal tender,
were convertible into greenbacks or gold. The national currency was
created at a time when Congress had suspended the convertibility of
greenbacks (issued by the Treasury) into gold; thus, it was not a foregone
conclusion that national bank notes would circulate at par value. The
bank notes would be issued by individual banks, and the Office of the
Comptroller of the Currency guaranteed that the Treasury would redeem
them at par value. Because of the required holdings of government securities,
it was unlikely that the Treasury would ever incur a loss in the event
of a national bank failure.
Narrow Banking Reconsidered
14 Public Policy Brief
Although the government now guaranteed that national bank notes
would clear at par, it did not guarantee that bank checking accounts
would clear at par. Thus, the same situation developed for checking
accounts as had previously existed for bank notes.4 Although the Federal
Reserve System was created to provide an “elastic” currency, it did not
adequately resolve the issue of providing a stable backing for the primary
means of payment. Unlike the National Banking Act solution, which
backed currency with government debt, the Federal Reserve Act sought
to back currency with short-term commercial loans (and gold). The
Federal Reserve also attempted to impose par clearance of bank deposits
on member banks, but with only mixed success until 1917 when new
legislation bolstered par clearance of member banks (Jessup 1967). The
problems with this backing of Federal Reserve notes became apparent
with the inability of the Federal Reserve to halt the widespread bank runs
and failures that began in the 1920s and culminated in March 1933 with
the closing of all banks in the United States. In response to this crisis, the
solution imposed in March 1933 was one that followed the principles set
forth in the National Banking Acts to provide a stable asset (government
securities) behind the means of payment.
Under the Emergency Banking Act to reopen the banks, federal government
debt became eligible as collateral for Federal Reserve discounts,
along with other bonds, bills, drafts, and acceptances, which were also
made temporarily eligible. Moreover, the Reserve banks could make
similar advances to any individual, partnership, or corporation on its
promissory note secured by U.S. bonds (Kennedy 1973, 177). Banks were
authorized to create special trust accounts for receipt of new deposits,
though banks were opposed to this on the grounds that those who had
funds were the ones who had hoarded them before the bank closings
(Kennedy 1973, 165).5 Confidence in the banking system was revived
without an explicit government guarantee of deposits, but public pressure
and congressional support (though not Roosevelt’s support) led to the
establishment of the federal deposit insurance system and the full restoration
of confidence in the banking system.
Using government debt to back the means of payment has been relied
upon throughout American financial history, and though periodically
other backing has been used, we have continually returned to the princi-
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 15
ples of the National Banking Act. Although the passage of the Banking
Act of 1935 expanded the use of government debt as a backing for the
money supply, the United States did not fully implement the principles of
the National Banking Act, but rather adopted a federal guarantee of
deposits. This set the stage for problems that would emerge in the 1980s
(Barth 1991). The policy prescription of the functional approach to
banking reform advocates a return to the principles of the National
Banking Act to establish a safe asset backing for the primary medium of
exchange, demand deposits.6
The Deposit Insurance Problem and the
Dual Function of Banks
The Banking Act of 1933 established temporary federal deposit insurance
and the Banking Act of 1935 made it permanent. As Carter H. Golembe
(1960) and Mark Flood (1992) have argued, this reform had support in
Congress, but not in the executive branch. Prior to the federal guarantee
of deposits, if a bank failed, the owners of equity lost their investment,
and, if necessary, depositors might have their accounts redeemed at something
less than par value. Another feature of the national banking system
prior to the 1930s was double liability. This meant that a bank shareholder
who held stock at, for example, the par value of $1,000 would be
liable for $1,000 on demand by the bank’s creditors if the bank had bad
loans and was in danger of failing. Presumably, double liability was an
incentive for shareholders to scrutinize a bank’s loan activities closely.
What Congress did in the early 1930s, in large part in response to its perception
of public demands for a safe payments system, was to guarantee
deposits and to abolish double liability. Why did Congress do this?
Two points are important in understanding the actions of Congress. First,
there was a general economic collapse in the real sector of the economy.
The financial system has little purpose when the real sector of the economy
has been devastated. Second, the Federal Reserve was restricted by
law, and by accepted practice, from lending to banks in crisis to the full
extent that the Federal Reserve could have done so in principle. For
example, the Federal Reserve could purchase only “eligible assets” from
banks. These assets were mostly short-term business loans (commercial
Narrow Banking Reconsidered
16 Public Policy Brief
paper), or in older terminology “real bills.” The Federal Reserve Banks
were also required to hold 40 percent in gold reserves against the total of
Federal Reserve notes issued.
Though the system appeared to function smoothly for several decades,
the inherent flaw of a system of unlimited contingent liability has long
been apparent. Deposit insurance dulls the incentives of depositors to
scrutinize the soundness of the depository’s assets and dulls the incentives
of the institution to maintain liquidity and asset quality sufficient to limit
the contingency of not meeting withdrawals (Tobin 1987, 171; Bryan
1991c, 74). The costs of regulating a payments system with federal
deposit insurance are high, as is most evident by the bailout of the savings
and loan industry (Barth 1991; Bartholomew 1990; Lawrence and Talley
1988, 345; Golembe and Mingo 1985, 132–135; Spong 1991, 5).
James Tobin (1985) expressed the basic dilemma. Our monetary and
banking institutions have evolved in a way that entangles competition
among financial intermediary firms with the provision of transactions
media; this entanglement is the source of risks of default and breakdown.
Protection against those risks has brought government interventions that
are now seen to have inefficient by-products: bureaucratic surveillance,
deposit insurance, and lender-of-last-resort guarantees by central banks.
Furthermore, Tobin believes, there is no complete resolution of this
dilemma, although we may hope to limit its scope.
This potential instability can be weighed against the benefits of our present
banking system. One argument is that banks, because they serve both
a depository and a lending function, have greater information about the
creditworthiness of potential borrowers. (In other words, they will lend to
a customer for whom they have a deposit record.) It is costly for others to
acquire this information. Because people wish to hold money in the convenient
form of bank liabilities, they find it cheaper to let the banker
check creditworthiness. This is a primary argument that efficiency is promoted
by fractional reserve banking, that is, by a monetary system requiring
that commercial banks hold some level of central bank liabilities
against the commercial banks’ own liabilities.7 There is also the argument
that provision of both deposit and lending functions allows firms to hold
lower cash balances, thereby increasing efficiency (Gilbert 1994, 14).
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 17
In summary, the response to Tobin’s view is that market forces played a
role in the evolution of fractional reserve banking, and it was not just a
matter of historical accident (James 1985; Pozdena 1991). These two different
views of banking, while not necessarily mutually exclusive, lead to
very different views of banking reform. Acceptance of the view that there
are efficiency gains from fractional reserve banking because of information
asymmetries underlies the policy recommendation of piecemeal
reform because banks perform a valuable service in providing both depository
and lending functions.
The efficiency view of banking implies that the problems with federal
deposit insurance are amenable to reform, for example, through the pricing
of deposit insurance. As originally established, fees were based on the
size of the bank, rather than the riskiness of its portfolio. However, riskbased
pricing of deposit insurance requires either a market indication of
the appropriate price or extensive government auditors and regulators to
review bank portfolios (Kareken 1985, 69–70). For publicly held banks,
risk would presumably be reflected in the stock price, though this would
not be a surefire indicator. Another possibility is the use of subordinated
debt as a mechanism to discipline banks because the holders of such debt
would have an incentive to monitor the bank’s loan activities (Kareken
1985, 72). Carter H. Golembe and John J. Mingo (1985, 138) doubt that
subordinated debt would prevent all bank failures. Others, such as Bert
Ely (1991) and Catherine England (1991), are more optimistic that privatization
and market discipline would correct the deposit insurance
Another modest reform would be to have the depositors pay for the
deposit insurance with an explicit fee. Some banks have done this as
insurance fees have been raised for banks. Increasingly, banks are passing
their costs directly to the depositors. Reform through increases in capital
has also been implemented, but capital increases threaten to create more
problems for weak banks, who have the greatest difficulty raising capital
f u n d s .
Ostensibly, federal deposit insurance was established to protect the small
depositor. The $5,000 limit established in the permanent program was a
compromise between the $2,500 in the Roosevelt administration’s first
Narrow Banking Reconsidered
18 Public Policy Brief
draft of the Banking Act of 1935 (also the level in the temporary program)
and the $10,000 advocated by Carter Glass. Today, the limit is
$100,000, which is approximately $10,000 in 1933 dollars. John H.
Kareken (1985, 58) has remarked in this context that a $1,000 limit
would take care of the low-income and unsophisticated investors.
None of these reforms resolve the dilemma that Tobin posed because
they do not directly address the issue that the government allows control
of the funds to remain in the hands of private agents, but at the same
time promises to make good on any deposits that are adversely affected
by bad or fraudulent loan activity of those agents. There is no convincing
macroeconomic reason why the government should guarantee
that a large financial institution will not fail (Tobin 1987, 169). As
James B. Burnham (1991, 36) notes, protection for depositors at the
largest banks is synonymous with an implicit policy that some large
financial institutions are “too big to fail,” that is, that they are too big to
be allowed to fail.8
The view of the narrow bank proponents is that any perceived benefits of
fractional reserve banking in terms of microeconomic efficiency must be
weighed against the macroeconomic costs. When this is done, they argue,
costs exceed benefits. The policy implication is that banks must be prohibited
from intermingling their depository and lending functions.
There were those in the 1930s who did not think that federal deposit
insurance was a desirable reform. When temporary deposit insurance was
enacted beginning in 1934, there was one banker who refused to join.
John M. Nichols advocated 100 percent reserve banking and practiced
what he preached (Phillips 1994b). Nichols was the president of the First
National Bank of Englewood, Illinois, established in 1891 on the south
side of Chicago. Nichols earned his nickname “100 percent” as a result of
his move early in the depression to liquidate his non-U.S. government
securities and loans and hold almost exclusively cash and government
securities. Nichols’s bank was the only one of the 6,000 banks required to
subscribe to federal deposit insurance to refuse to join the FDIC. Nichols
was not alone in his view that banks were primarily responsible to their
depositors and stockholders. Because loans were risky during the early
1930s, he advocated holding only safe assets.
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 19
At the same time proposals came from a number of prominent
economists who began to question whether it was desirable for banks to
provide both depository and lending functions (Phillips 1994a). In March
1933 economists at the University of Chicago, including Henry C.
Simons, Frank Knight, Lloyd Mints, and Paul Douglas (later Senator
Douglas), circulated a proposal that called for the abolition of fractional
reserve banking—the separation of the deposit and lending functions of
banks—and the establishment of a federal monetary authority to conduct
monetary policy under definite rules established by Congress. The proposal
was based fundamentally on Article 8 of the Constitution, which
gives Congress the sole right to coin money and protect the value thereof.
The proposal to abolish fractional reserve banking sought to make monetary
policy once again the prerogative of Congress.
In short, these economists believed that because bankers could be presumed
to put their own self-interests above those of society, and because
politicians had a penchant for abusing the lending powers of government,
it would be in society’s best interest to separate the respective banking
functions and have Congress make definitive provisions for each. The
economists believed that their proposal would reconcile the divergence of
private and public interests in a manner consistent with the problems of
centralization of economic and political power. The worst possible combination
would be to have the government insure commercial lenders’
deposits and then leave lending discretion to the banks. The overall
vision was of a financial system with deposit banks serving essentially a
warehouse function as trustees, small mutual savings associations for lending,
and a centralized monetary authority. It was recognized in the 1930s,
at least by some observers and participants in financial reform, that banks
could not be permitted to serve their dual function in payments and lending
without introducing the potential for the effective nationalization of
the banking system. To avoid this eventual outcome, they believed that a
clear statement by Congress of government’s role in the payments and
credit systems was absolutely essential for the continued smooth functioning
of the financial system and for the stability of the real sector of the
e c o n o m y .
Narrow Banking Reconsidered
20 Public Policy Brief
Defining Government’s Role in the Payments
System and Lending
The separation of the depository and lending functions of banks requires
a parallel separation in the role of government. Currently, one of the
main duties of the Federal Reserve is to undertake policies that lead to
the creation of an amount of money in the economy consistent with full
employment and price stability. Through the use of its tools—reserve
requirements, open market operations, and the discount window—the
Fed adjusts bank reserves and, depending on the multiplier, the money
supply grows accordingly. At the same time the Fed is also responsible for
the growth of credit. In fact, we have come to view these tasks as intertwined
because under the present system monetary policy is simultaneously
credit policy. As Mingo (1985, 7) observes, the logical outcome of
this system is that the Federal Reserve must regulate and supervise more
of the financial system. This is because the Fed does not have a great deal
of control over the money supply as the definitions broaden beyond M1.
The functional approach to reform would separate monetary policy from
credit policy, which would mean that the Federal Reserve would play the
major role in monetary policy and have only a minor involvement in
l e n d i n g .9 Kareken (1985, 65) has argued that in the absence of government
involvement, laissez-faire would have provided us with a safe and
stable payments system. He reasons that fractional reserve banking would
not have been tolerated by individuals and, therefore, would have lost in
market competition.1 0 Tyler Cowen and Randall Kroszner (1990) have
taken this premise and argued that mutual fund banking is the wave of
the future if government will reduce its involvement.1 1 The dramatic
growth of mutual funds and their increasing acceptance, despite the lack
of explicit government guarantees, lends credibility to this argument.
However, the problem for mutual fund banking without commodity
money is that the central bank is left as the ultimate supplier of “outside”
money, and mutual fund shares are ultimately redeemable in central bank
m o n e y .
The problems, therefore, are not necessarily solved by abolishing the central
bank’s monopoly on the issue of the monetary base. Tobin argues that
a system of private competitive money would be inefficient because it
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 21
would not be possible for the government to define a “dollar” as the unit
of account and not issue a medium of exchange in the unit of account.
Private banks could promise to pay dollars, but precisely what would they
be promising to pay? Only if the government granted the private institution
some exclusive rights in the issuing of government money—delegated
its fiat in other words—would the money in fact circulate as a
medium of exchange. The case of the Bank of England suggests that
where an institution is granted legal tender status, the bank would eventually
be brought under government control (Tobin 1985, 21).
Even under a commodity money system, the government must play a role
in defining the numeraire. In doing so, the government will inevitably
become involved with the production of money. Tobin contends that
whatever inefficiencies there might be in the government’s monopoly in
currency supply, they are mitigated very little by having private issue of
currency and coin (Tobin 1985, 22). Any gains in efficiency, and Tobin
argues that these would be small, would have to be weighed against the
inconvenience of handling and sorting different kinds of notes and coins.
As an example, during the free banking era each bank had to have a book
that depicted an example of every kind of note issued by every bank in
the country. Though improvements in technology might reduce these
costs today, private bank notes would lend themselves to an increase in
counterfeiting. Tobin concludes that because a payments system derives
efficiency from standardization and predictability, a system of competing
currencies with varying exchange rates is not efficient (Tobin 1985, 22).
In contrast to the view that government should play a crucial role in the
payments system, the proponents of the functional approach would
reduce government’s role in private sector borrowing and lending to a
largely supervisory one (Golembe and Mingo 1985, 140–141; Spong
1991, 9). One goal of the approach would be to reduce substantially the
impact of government monetary policy on the private credit market.1 2
This would be a radical departure because, as noted above, presently
monetary policy is simultaneously credit policy, and open market operations
are intended to affect bank reserves and therefore the amount of
private sector lending by banks. This change removes an asymmetry in
the conduct of monetary policy. As a result of the fractional reserve system,
which relies on the profit-maximizing behavior of banks, it is easier
Narrow Banking Reconsidered
22 Public Policy Brief
for the Federal Reserve to restrain credit growth than it is to stimulate
credit growth. When banks wish to accumulate excess reserves, there is
little the Federal Reserve can do to cajole the banks into lending.
The difficulty with the Fed’s undertaking credit and monetary policy
simultaneously is evident in the rhetoric of politicians. On the one hand,
as a result of the savings and loan problems, government regulators are
looking over the shoulders of banks to make sure they are not making bad
loans. On the other hand, when the economy slows down, politicians
clamor for banks to lend more to get the economy moving. The problem
is obvious: Banks lend “too much” when times are good and “too little”
when times are bad. After having castigated the banks for their actions in
the 1980s and exhorting them to get their house in order, the same people
are vehement in their attacks on the banks for paying 3 percent on
deposits while charging 19 percent on credit cards. The functional
approach advocates argue that this is not a problem that can be adequately
resolved under the present financial structure.
With the functional approach the Federal Reserve would still have its
three tools of monetary policy: reserve requirements, open market operations,
and the discount window. The Federal Reserve would continue to
operate in large part as it does today. The main difference would be that
changing the money supply through open market operations would not
necessarily imply changing the amount of private sector credit because
monetary policy would immediately affect only the balance sheets of
institutions holding liabilities backed by government debt.1 3
Monetary Service Companies
The proposals that emanate from the functional approach seek to remedy
the problems of the payments system by restricting to only safe assets the
portfolios of financial institutions offering transactions or checkable
accounts. Litan (1987a) termed such institutions “narrow banks” and,
more recently, “monetary service companies” (Litan 1993; Pierce 1993).
The underlying assumption is that the primary role of banks is to provide
a means of payment (Hart 1991). Some would make this compulsory
(Tobin 1985, 1987; Lawrence and Talley 1988), while others would make
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 23
it voluntary or make it apply only to larger, diversified institutions (Litan
1987a; Spong 1991; Burnham 1991). In restricting assets, the proposal
continues in the tradition of banking legislation at least since the
National Banking Acts of 1863 and 1864 (Pollock 1991).
All of the proposals agree that the intent of asset restriction is to reduce
the private credit risk of the banks’ portfolios. The five types of risk that
narrow banking seeks to reduce are credit risks (bad loans), interest rate
risks (maturity), affiliate risks (failures and raids on narrow banking
assets), activity risks (bond, foreign exchange trading), and fraud risks
(Lawrence and Talley 1988, 346). There is some difference, however,
about what constitutes safe assets.
Kareken (1986, 39–40) has argued that financial institutions offering
transactions balances should be restricted to offering only such balances
and should be subject to a 100 percent reserve requirement in the form of
marketable Treasury debt. In essence, banks would be split into separate
businesses or companies. The narrow bank would be like a mutual fund,
which would operate effectively to break up big pieces of government
debt into little pieces (Golembe and Mingo 1985, 139; Lawrence and
Talley 1988, 347).
Tobin (1985) proposed the creation of “deposited currency,” which
would combine the convenience of a checking account with the safety of
currency. Deposited currency would be subject to 100 percent reserves in
U.S. Treasury liabilities (short-term government securities) or in Federal
Reserve deposits held by the banks. Deposited currency would be payable
in notes and coin on demand, transferable by order to third parties, and
secure against loss or theft. It would be a perfect store of value in the unit
of account. One way to provide it would be to allow individuals to hold
deposit accounts in the central bank, in branches of the central bank
established for the purpose, or perhaps in post offices. A more likely alternative
is to allow any bank or depository institution that is entitled to
hold deposits in the central bank to offer deposited-currency accounts to
customers. To enable the payment of competitive rates on the deposited
currency, the Fed could subsidize them by paying interest on the noncash
portions of the reserves (Tobin 1985, 25). The chief purpose of deposited
currency would be to allow a totally safe asset to be held by low-income
Narrow Banking Reconsidered
24 Public Policy Brief
and less sophisticated financial investors (Tobin 1987, 173; Kareken
1985, 57).
In Kenneth Spong’s (1991) version of the proposal, narrow banks would
hold primarily cash, Federal Reserve balances, and short-term U.S. government
securities. In order to assure an adequate supply of short-term
government debt, Spong recommends that the Treasury substitute
shorter-term debt for longer-term in its offerings. If the amount of safe
government liabilities was insufficient, the range of assets could be
expanded to include other high quality, short-term debt.1 4
Alice Haemmerli (1985, 8) proposed the creation of a “consumer bank”
that would have 100 percent FDIC insurance coverage, no upstreaming
of funds from the consumer bank to any other subsidiaries, close regulation
of the bank, and no limitations on geographic expansion. James B.
Burnham (1991, 36–37) would allow narrow banks to hold Federal
Reserve deposits, as well as deposits of other banks, both domestic and
foreign, U.S. government securities of any maturity, and most government
agency securities. Stuart I. Greenbaum and Arnoud W. A. Boot
(1991, 4) would allow any investment-grade assets, private or government.
Lowell Bryan’s (1991, 79) proposal is the least restrictive on assets
and would allow banks to engage in traditional or “core” activities.1 5
“Core banks” would be permitted to lend to individuals for mortgage
loans, home equity loans, credit cards, installment loans, and auto loans.
The banks would continue to lend to businesses for accounts receivable
financing, equipment leasing, commercial mortgages, and unsecured lines
of credit. In short, Bryan would allow banks to continue in those activities
in which they have been engaged for more than a century and have
demonstrated a competitive advantage over nonbanks. However, banks
would certainly not have an advantage in services such as individual
mortgage and auto loans.
Similar to the idea of the core bank is Tobin’s proposal that commercial
banks be allowed to offer insured deposits and hold a diversified portfolio
of short-term paper, including Treasury bills, marketable commercial
paper, nonmarketable commercial loans, consumer debts, and longerterm,
variable rate bonds and mortgages (Tobin 1987, 174). They would
not be allowed to use depositors’ money to play zero-sum games in foreign
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 25
exchange, interest rates, and securities prices. The capital account of
these commercial banks would take the form of preferred stock or debt of
the holding company of which the bank is a subsidiary, equal at least to a
federally set fraction of the bank’s assets, but not less than 5 percent.
Another similar proposal, put forward by L. William Seidman, former
head of the Federal Deposit Insurance Corporation, would allow for what
he termed “two-window banking” (FDIC 1987, 1992; Carns 1994). A
two-window banking firm would allow savers to choose between
“insured” and “uninsured” windows in which to deposit their funds. Funds
placed in the insured window would receive deposit insurance and would
be used by the banks to finance traditional banking activities: short- and
intermediate-term commercial lending and clearing payments. There
would be no restrictions on the activities in the uninsured window, since
the activities would occur in legally separate institutions.
It should be noted that as one broadens the range of safe assets, the credit
risk increases. It is for this reason that many of the core bank proposals
include additional features such as increased capital requirements, interest
rate ceilings, risk-based premiums, and other features found in less
asset-restrictive proposals (Bryan 1991c, 79–80; Hart 1991, 17). One of
the important advantages of narrow banks is that they would not need
very much capital. To the extent that they did incur more credit risk,
capital requirements would be raised. However, small capital requirements
could take care of any remaining risk, and we would have a more
stable payments system (Lawrence and Talley 1988, 347, 352). Federal
regulators would no longer have to worry about private sector risk factors,
such as shopping mall vacancy rates, creditworthiness of developing
countries, and oil prices (Burnham 1991, 37). Frederick S. Carns (1994,
11–12) argues that there are benefits from additional risk-taking, and the
two-window proposal would allow a middle ground between narrow
banks and universal banking.
Financial Service Companies
The establishment of federal deposit insurance inhibited the growth of
alternative, noninsured lending institutions.1 6 Writing several years after
Narrow Banking Reconsidered
26 Public Policy Brief
the New Deal banking legislation, Henry C. Simons, a professor of economics
at the University of Chicago and one of the founding fathers of
the “Chicago School” of economics, expressed the view that banking
continued to exist because of just such a failure to promote new lending
i n s t i t u t i o n s .
One reason for the persistence of banking is our lamentable failure
to develop proper institutions for mobilizing the savings of middleincome
families. If legislatures and economists were more concerned
about giving us good, small investment trusts and less concerned
about making bank accounts and life insurance safe and salable, we
might get a better structure of financial organizations. (Simons
1948, 340)
With the functional approach to banking regulation and supervision, savings
would be channeled to investors through separate investment instit
u t i o n s .1 7 The simplest way to envision the financial structure is to look
at a simplified bank balance sheet.
A s s e t s Liabilities Plus Capital
R e s e r v e s Demand deposits
Government securities
L o a n s Bank capital
Without the thick line you have a typical balance sheet of a bank today;
with the line you have the division of the bank into two legally separate
entities. This “fire wall” between the two is necessary because in reality
the division would have to be absolute. If there were a clear and clean
line between depository and lending activities, caveat emptor could apply
to the uninsured and less regulated business, where financial institutions
would be vigorously competing with each other and with other market
participants (Tobin 1985, 27). The fire wall is especially important to the
two-window proposal because a single firm could pursue the activities
involving insured and uninsured deposits (Carns 1994, 16–17).1 8
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 27
Although there would not seem to be a need to restrict the ownership of
narrow banks, there would be a problem if the narrow bank assets were
used to bail out a subsidiary owned by the holding company that also
owned the narrow bank (Mingo 1987, 13). It is for this reason that, if
narrow banks are to exist within a financial holding company, the narrow
bank assets must be separate and unreachable (see Gilbert 1987, 13).
Maintaining corporate separateness is both desirable and feasible.
Golembe and Mingo present the strongest arguments that maintaining
separateness is legal. Though they admit that there is the possibility that
a bank holding company might strip the narrow bank of assets to protect
another subsidiary, on balance the number of problem situations would
not be great and the law is sufficiently effective that corporate separateness
would be an appropriate regulatory vehicle (Golembe and Mingo
1985, 142; Gilbert 1987). A policy of unrestricted ownership of narrow
banks would likely require the examination of the consolidated holding
company. If this were not the case, the Federal Reserve might argue that
fire walls were insufficient and that the Basel agreement would be violated.
Supervision of the holding company could create an artificial
impediment to entry by nonbanking firms.
Litan (1987a, 165), one of the earliest proponents of narrow banking,
would authorize the creation of new financial holding companies, which
would be required to separate their deposit-taking from their lending
activities. In his version then, the narrow bank proposal would be an
option—or enticement—for large, highly diversified financial holding
companies that wished to offer transactions accounts. The narrow or safe
banks of such holding companies would be required to operate as mutual
funds investing only in highly liquid, safe securities, such as Treasury or
other federally guaranteed instruments. The holding companies could
extend loans, but only through separately incorporated lending subsidiaries
wholly funded by uninsured liabilities.
Tobin (1987, 177) would allow bank holding companies to have investment
bank affiliates that would be totally uninsured. They would be subject
to disclosure requirements like those of the Securities and Exchange
Commission and to balance sheet restrictions like those of the
Investment Company Act of 1940. A complete separation would be
Narrow Banking Reconsidered
28 Public Policy Brief
made between the activities of the investment affiliates and those of the
commercial (narrow) banks.
The Problems Solved
The proposal to establish separate monetary and financial service companies
solves several problems with respect to the financial system. It
enhances the safety of the payments system, improves the Fed’s ability to
control monetary aggregates, reduces the need for government regulation
of banks, and accommodates, and perhaps accelerates, the growth of
mutual funds. The proposal would make federal deposit insurance redundant,
and the insurance logically could be done away with or maintained
with minimal, if any, fees. Under Tobin’s (1987, 173) proposal, deposit
insurance would not be necessary for deposited currency, although it
would be retained for commercial banks. Burnham (1991, 36) would
expand deposit coverage to all deposits in narrow banks, thereby removing
the $100,000 limit. Spong (1991, 23–24) would extend deposit insurance
to narrow banks, although it would be only to protect against fraud
or macroeconomic collapse.
The central bank would have effective monetary control over the M1
money supply (currency and checkable accounts) because this will be the
monetary base. Monetary control via reserve tests is effective if and only
if the government, via the central bank, monopolizes and controls the
aggregate supply of eligible reserve assets, the monetary base. A crucial
assumption, as Tobin (1985, 28) points out, is that banks still remain
weighty enough participants in financial and capital markets so that central
bank operations affect quantities, prices, and interest rates determined
in those markets. The monetary aggregates may not be useful as
targets, but the Fed’s tools will still affect the monetary base and will be
transmitted to the macroeconomic variables. The payment of market
interest rates on deposits will reduce the tendency to short-run shifting of
accounts. In short, the money supply becomes more sensitive to interest
rates (Tobin 1985, 29).
Another change will be more supervision and less regulation. As
Golembe and Mingo (1985, 132) note, to regulate means to direct
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 29
according to rule and to supervise means to oversee for direction. Thus
regulation sets a minimum capital-to-asset ratio, while supervision determines
whether capital at any individual bank is adequate. For narrow
banks, supervision is required in order to determine if the bank is indeed
holding assets valued at market equal to its deposit liabilities. This should
be a rather simple and low-cost task in the age of computers and highly
developed securities markets. The two-window proposal would gain many
of the benefits of narrow banking, but would require continued vigilance
by Congress on bank structure and competition (Carns 1994, 18).
Finally, the proposal will accelerate the growth of mutual funds as
investors seek higher returns. This does not mean that narrow banks will
eventually disappear. As long as government money is the outside money,
there will be a demand for it. The public continues to hold currency
when it pays no interest, and there is no reason to believe that the public
would not find it convenient to continue to hold some balances in narrow
banks. Even if the size of the narrow banking sector declines, there is
no reason to view this with alarm. Changes in technology and tastes will
make other types of money and financial assets more attractive or less
attractive. There is no theory that suggests that outside money must bear
a given ratio to financial assets in order to maintain monetary control
and stability. The proposal thus fits in quite well with the historical evolution
of the financial system.1 9
The Problems Raised
Alton Gilbert provides the following summary of the assumptions
implicit or explicit in the functional approach to banking reform, or the
narrow banking proposals.
1 . Fractional reserve banks, with deposits payable on demand, are vulnerable
to runs by depositors.
2 . Disruptions in the operation of a nation’s payments system disrupt its
economic activity.
3 . A valid reason for government regulation of banks is to avoid disruptions
in the operation of the payments system.
Narrow Banking Reconsidered
30 Public Policy Brief
4 . The government can ensure safe operation of the payments system
without assuming risk by insuring all transactions deposits, but not
time and savings deposits, and requiring collateral against the transactions
5 . These narrow banking restrictions will not diminish the efficiency of
intermediation. Elimination of federal insurance of time and savings
deposits and elimination of supervision of banking risk would make
intermediation more efficient. (Gilbert 1993, 4)
Other than proponents of extreme laissez-faire, most economists would
probably agree with assumptions 1, 2, and 3. The crucial assumptions are
4 and 5, and these must be addressed. Gilbert argues that assumption 4 is
problematic because a narrow bank would likely hold balances from foreign
banks, permit daytime overdrafts, and hold foreign exchange, all of
which have the potential to bring about loss and perhaps failure of these
“safe” banks. One way to deal with this would be regulation and supervision
along the lines of the current institutional arrangements; the alleged
superiority of narrow banking is thus undermined, according to Gilbert
(1993, 6).
The points Gilbert makes are valid, but it is not clear that they totally
invalidate the narrow banking proposals; rather they provide a recognition
that, as with any proposal for reform, the costs and benefits of the
proposed reform must be compared with the present system. Clearly, the
problems that Gilbert points to are problems confronted by the present
institutional arrangement, but this arrangement also contains the moral
hazard problems associated with deposit insurance. Institutional innovations
require adjustments, and undoubtedly the proposal emanating from
the functional approach is not a panacea. However, there are five basic
problems raised by narrow banking that could create difficulties for any
transition and, as will be presently discussed, the impact on credit markets
(assumption 5 above) is one of the most important for evaluating the
The first question is the availability of safe assets with the appropriate
maturity for a narrow bank (Litan 1987a, 169; Lawrence and Talley 1988,
349). To reduce credit risks, U.S. government securities are the most
desirable. These need to be short-term government securities if interest
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 31
rate risk is to be avoided. In 1990 total demand and checkable deposits
were $571 billion, while government securities held by the depository
institutions were about $448 billion. The total outstanding amount of
Treasury bills was $482 billion and of Treasury notes $1,218 billion. Total
outstanding debt was $3.2 trillion, of which $2 trillion was marketable.
One solution to the problem supported by both Spong (1991, 22–23) and
Robert J. Lawrence and Samuel H. Talley (1988, 349) would be for the
government to alter the maturity structure of the Federal debt. Because
short-term rates are usually lower, there would be the additional benefit
of reducing the costs of borrowing.
This problem is reduced as the class of permissible assets increases, but
the trade-off is increased credit risk (Lawrence and Talley 1988, 350).
Proposals such as those of Bryan (1991c) for core banking do not have a
real problem of adequate assets because of their broadening of assets that
can be held. Others, such as Burnham (1991) and Spong (1991), avoid
the problems through allowing a long transition period (5 to 10 years)
and applying the proposal only to a subset of depository institutions.
Tobin (1985, 25) and Lawrence and Talley (1988, 347) would allow
interest to be paid on reserves.
There is potentially a large impact on the costs and availability of funds
in the credit market. A particular problem may be the availability of
funds for small business loans and consumer loans. There are responses to
these concerns (Minsky, Papadimitriou, Phillips, and Wray, 1993;
Papadimitriou, Phillips, and Wray, 1994). First, if the supply of savings
goes up as a result of this structural change, then there is no reason to fear
an enormous increase in interest rates. Even if the cost does increase by a
small amount, it is the price we are paying for stability of the payments
system without federal deposit insurance (Burnham 1991, 43). Second,
there would likely be an increase in the use of finance companies for
many of the small business and consumer loans (Burnham 1991, 43;
Bryan 1991c, 80). Again, once the subsidy for banks is removed, what
the impact of the increased use of finance companies will be remains an
open question. The finance companies must use uninsured deposits to
finance their loans. Finally, if there really was a great concern over the
decline in credit availability and cost, the government through the
Federal Reserve or through a resurrected Reconstruction Finance
Narrow Banking Reconsidered
32 Public Policy Brief
Corporation could make direct loans to the private sector. The government
could also guarantee, subsidize, or help create new markets for loans
that were less marketable. This would be no different than Small Business
Administration lending, FHA and all other agency mortgage lending, the
Farm Credit System, and community development financial institutions.
In fact, it might help to focus the debate on what markets and borrowers
have informational and marketability problems that cannot be resolved
through other means. These lending activities would have to be done
under specified, and explicit, legal constraints (Bryan 1991c, 84;
Lawrence and Talley 1988, 356).
Another alternative would be voluntary narrow banking to divide the
industry into companies with marketable balance sheets and those without.
Bryan (1988, 92) points out that developments in technology have
allowed the securitization of many kinds of loans. Presumably, one possibility
is that small business loans and consumer loans could be securitized,
just as home mortgages and credit card receivables now are (Bryan
1988, 77).
Another serious problem is access to the payments system. For the narrow
banking scheme to work, only narrow banks can have access to the
Fedwire and the payments system. If there is an Achilles heel for narrow
banking, this may be it, for it requires absolutely that the government
prevent banks from gaining access.2 0 This is why a number of authors
refer to the “Chinese wall” (Burnham 1991, 37; Lawrence and Talley
1988, 348) or, in Haemmerli’s (1985) term, a quarantine of the bank. Of
course, there will be a strong incentive for nonnarrow banking firms to
get around this restriction. By gaining access to the payments system and
offering higher deposit rates, they could effectively undermine the entire
scheme. However, it might be difficult for such institutions to offer rates
that are much higher without assuming much higher risks. A narrow
banking system should be fairly efficient in transferring portfolio returns
to depositors, and any competitors would have to narrow their asset
choices if they are to reach the same depositors (consider money market
mutual funds as an example). To save on clearing costs or to gain better
clearing services, these competitors might even have a strong incentive to
convert to narrow banks.
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 33
Though all proponents of the narrow banking scheme believe that such
banks would be profitable, it is recognized that the size of the banking
system might shrink. The traditional banking sector may shrink anyway
with the current regulatory approach, and deposit insurance concerns
will undoubtedly slow bank entry into other areas. The point of comparison
must then be whether an insured and restrictive system is more
viable in the marketplace than a narrow banking system with few, if any,
restrictions beyond narrow bank asset holdings. As noted above, there is
no reason to believe that this is undesirable (Mingo 1987, 9). Gilbert
(1990) argues that, from an analysis of functional cost data, the opportunity
costs of holding government securities compared with other assets
would indicate difficulty in narrow banks’ earning a competitive rate of
return. This analysis is countered by evidence that for the period 1968 to
1989 the average earnings by use of funds as a percentage of portfolio
balances was highest for investment (government security) portfolios
(Morgan 1991, 13).
Gilbert (1990, 16–17) also points out a potential difficulty with overdrafts,
which are quite common in the financial system. Overdrafts
expose banks to credit risk; this would continue to be the case for narrow
banks holding deposits at other banks and conducting significant clearing
operations. The giro system, or extensive use of debit cards, as proposed
by Tobin, would reduce this risk exposure. However, to effectively prohibit
the credit risk would raise costs, and this would raise the incentive
to circumvent the narrow bank restrictions (Gilbert 1990, 18).
With respect to international competition, all foreign banks operating in
the United States and accepting transactions deposits will be subject to
the same restrictions. For the uninsured lending institutions, it is likely
that it will be a few large holding companies or investment firms that will
continue to compete globally. Bryan (1991c, 80) envisions a few large
investment institutions, such as J. P. Morgan, continuing to operate on a
global basis without insured funds. Burnham (1991, 41) also believes that
the highly diversified financial institutions, once freed from regulations,
will be globally competitive with their uninsured deposits. We could also
allow narrow banking organizations to set up separate holding companies
or edge corporations to engage in foreign banking activities, but these
would have to be capitalized and regulated according to international
Narrow Banking Reconsidered
34 Public Policy Brief
standards and should have limited, if any, access to the federal safety net.
Because depositor preference and current deposit insurance procedures
put foreign depositors in back of insured deposits, the change to a narrow
banking system might not be much different.
Finally, how politically feasible is narrow banking? L. William Seidman
(1991) agrees in principle with the intent of the narrow banking reforms.
However, it may well be that we will await a catastrophe on the level of
the Great Depression. The alternative is to move toward the less restrictive
core banking and hope that continued changes in market forces and
regulation will move us toward a more stable banking system.
The New Regulatory Environment
Recently, the issue of restructuring the bank regulatory agencies has
resurfaced as a result of Treasury Department’s proposal to consolidate all
bank regulatory and supervisory authority into a Federal Banking
Commission. This proposal continues a debate that has been going on at
least since 1919 (U.S. General Accounting Office, 1977; Shull 1993;
Phillips 1994a). The burden of the multiregulatory structure has provided
an impetus to find a more cost-effective means of regulating the financial
system and to eliminate or reduce the inherent conflicts of interest. The
functional approach would involve an even more radical restructuring
because financial institutions would be regulated on the basis of their
f u n c t i o n .
Are banks as we know them today doomed? They probably are, but this
does not mean that they will disappear. We are in a period in which fundamental
change, driven in large part by technology, has radically altered
the possibilities for financial institutions. Increasingly, there are those
who believe that a system that utilizes federal deposit insurance and government
regulation and supervision cannot persist for long. A key policy
question for today is whether government policy should continue to push
the financial system along the lines of separating the deposit and lending
functions of banks or attempt to maintain the current role of banks in
offering deposit and lending functions with federal deposit insurance.
Further complicating the issue is the prospect of expanded antitrust
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 35
action by the Justice Department as a consequence of concerns about the
maintenance of a competitive environment (Shull 1994).
There is a wide perception that the financial system, not only in the
United States but worldwide, has a difficult road ahead. At some point
change will be forced. If we alter present institutions, the impact of that
change may be mitigated. If we do nothing, we may be risking a financial
collapse of enormous magnitude. Even without a collapse, we will continue
to suffer the costs of regulation and the federal safety net as we
operate with a less efficient and less stable financial system. The challenge
is to present a viable proposal, in an era of rapid technological
change, that provides an appropriate balance between a governmentbacked,
safe payments system and the demands of a dynamic market
economy with expanding financial opportunities.
A Policy Proposal
The mixture of deposit and credit functions in our financial system has
continued to provide an unstable and risky banking structure, which we
now support through deposit insurance and an extensive federal safety
net. The recent taxpayer bailout of the thrift system and the losses experienced
by the bank insurance fund indicate some of the weaknesses in this
safety net. Also, the use of deposit insurance has given the poorest bank
lenders the same access to funds as the most discerning lenders—a situation
that is unlikely to have led to an optimal allocation of credit. This
misallocation, while it has received little attention, has probably cost the
economy far more than the taxpayer bailout of the thrift industry (Spong,
forthcoming). Looking at the current state of the financial system, we see
that banks are losing lending business to commercial paper and mutual
funds, finance companies, and others. Congress and the public will continue
to be interested in safeguarding the payments system, and any conceivable
changes in deposit insurance—other than its abolition—will be
unlikely to reduce the regulatory burden.
Legislation and regulation designed to control banking risks and to safeguard
deposits and the insurance funds have put banks at a competitive
disadvantage and imposed unnecessary costs. This helps explain why
Narrow Banking Reconsidered
36 Public Policy Brief
banks are losing loan business. In addition, cash management accounts at
brokerage houses and money market mutual funds with check-writing
privileges are helping to show the feasibility of using a secured asset structure
to back transactions accounts. A driving force in the changes in
banking has been the technology that has provided a means for new and
more efficient credit markets to develop and is now reducing any real
need for using liquid deposits to fund loans. If the technology today had
been available in 1933, the separation of the deposit and lending functions
of banks would have been more feasible.
Although deposit insurance is flawed, it is likely to remain for political
reasons. What are alternative proposals today that would provide for both
a safe payments system and the efficient channeling of funds from lenders
to borrowers? There are two proposals, which taken together, would go a
long way toward improving our financial system: voluntary choice for
banks to become monetary service companies, or narrow banks, and the
establishment of a mutual fund operated by the federal government and
backed by government securities.
The first recommendation is to adopt the proposal of Robert E. Litan and
James L. Pierce to create monetary service companies (Litan 1993; Pierce
1993). These institutions would serve strictly a payments function and
would hold only safe assets such as cash, government securities, and
high-grade commercial paper. Financial institutions that wished to offer
federally insured deposits would have to operate as monetary service
companies. As previously noted, this idea is a modification of Litan’s earlier
proposal for the creation of narrow banks (Litan 1993; Pierce 1993,
1 0 – 1 1 ) .
The second proposal, authored by James R. Barth and R. Dan
Brumbaugh, Jr., was presented in their Public Policy Brief (1993, 27–28).
They propose that the federal government establish a mutual fund that
holds only government securities as assets. There already are a number of
private mutual funds that hold government securities. The Barth and
Brumbaugh proposal would make this option available to all desiring a
safe place for deposits. Such a mutual fund would not need federal deposit
insurance. The assets of the fund would be short-term Treasury securities,
and liabilities would be only demand deposits. There could be electronic
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 37
deposits of all government checks. The banking services provided would
be a large-scale electronic debit and credit mechanism with retail outlets,
perhaps at the Post Office, much as the postal savings system once operated
(Jessup and Bochnak 1992).
These proposals will provide for a safer and more efficient financial system
that will carry us into the twenty-first century and would go a long
way toward creating the kinds of institutions that Henry Simons believed
would move us toward the financial good society.
Narrow Banking Reconsidered
38 Public Policy Brief
A c k n o w l e d g m e n t s
Ken Spong, Fred Carns, John Carlson, Phil Bartholomew, Alex Pollock,
and Alton Gilbert provided helpful comments, but should not be held
accountable for the views expressed.
N o t e s
1. The functional approach to banking regulation should not be confused with
“functional regulation,” the proposal that the SEC regulate all securities
activities, insurance commissioners regulate insurance activities, and so on.
Pierce’s functional approach is limited to banks and their deposit activities
and does not include the regulation of the expanded activities of banks.
2. Though it has emerged in the past decade, the functional approach has historical
precedent, as does the narrow banking proposal. In the 1930s Henry
Simons, Frank Knight, Irving Fisher, Lauchlin Currie, and others proposed
the separation of the depository and lending functions of banks through the
creation of 100 percent reserve deposit banks and separate lending organizations
established on a mutual basis (see Phillips 1994d). Litan (1987a, 166),
Kareken (1986, 39) Golembe and Mingo (1985, 139), and Minsky (1994)
explicitly recognize this historical connection. Benston and Kaufman (1988)
make the point that, strictly speaking, the original version of the 100 percent
reserve plan meant 100 percent cash reserves. Later versions of the 100
percent reserve plan, such as Friedman (1960), allowed for payment of interest
on reserves.
3. According to Robertson (1968), as early as 1815 an author in A n a l e c t i c
Magazine suggested a national, uniform currency that would be redeemable
in either specie or government debt. In 1827 Professor John McVickar published
“Hints on Banking,” in which he suggested each bank invest ninetenths
of its capital in government debt pledged against its note redemption
(Robertson 1968, 36–37). Robertson discusses three specific plans to base a
uniform national currency on government debt presented to Treasury
Secretary Salmon P. Chase in 1861 (Robertson 1968, 36–40).
4. As Cyril James observed, “the National Banking Act failed to attain its purpose
for reasons similar to those that had prevented the attainment of the
aims of the Currency School under the Bank Charter Act of 1844” (James
1940, 198). The Bank Charter Act divided the Bank of England into lending
and issuing departments. However, the creation of alternatives to Bank
of England notes undermined the attempts to regulate the money supply
through the establishment of a par value monopoly for the Bank.
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 39
5. I am grateful to Alex Pollock for bringing this to my attention. Pollock calls
the principle employed in the National Banking Acts and the Emergency
Banking Act of backing money with “safe” assets “collateralized money.”
6. The use of government debt as a stable backing for money assumes that such
securities are “default-free.” There have been numerous instances in history
where sovereign governments have, in fact, defaulted. However, assuming
continued political stability in the United States, the continuation of federal
government powers of taxation, and the ultimate monetization of federal
debt, the risks of default appear negligible. If the U.S. government were
to default on its obligations, more serious problems would arise that would
likely overshadow provisions for an acceptable means of exchange.
7. Under a fractional reserve gold standard, as it operated in the United States
before the New Deal, gold was held as reserves against bank liabilities.
8. The phrase “too big to fail” is a misnomer. Policymakers fear the consequences
of allowing large banks to default on their debts, but no one fears
the consequences of wiping out stockholders. The phrase “too big to default”
is more descriptive of the problem.
9. As noted, a basic premise of the functional approach to banking reform is
that the money issued by the federal government should be backed by stable
assets. Though this implies that the Federal Reserve would control M1, it
does not necessarily mean that government should have a monopoly on all
forms of money. Indeed, in a system characterized fundamentally by financial
innovation, it is impossible to define only one thing as money. There is
an interesting discussion of this issue in correspondence between Henry
Simons, who favored, in principle, a government monopoly based on money
creation, and F. A. Hayek, who argued that such a monopoly could not be
maintained over time (see Phillips 1994d).
10. Benston and Kaufman [1988, 56] point out that money market mutual
funds, which guarantee return but not nominal value, have largely given
way to the opposite, presumably in response to the market. The conclusion
is that the public wishes to have a guaranteed nominal value, even at the
expense of return. The question not addressed is whether the result would be
the same in the absence of government money with a guaranteed nominal
value. To date, all money market mutual funds operating in the United
States are redeemable in government money. The two-window approach, as
described by Carns (1994), stands or falls with this observation, which, if
true, raises the issue of whether sufficient funds could be raised to finance all
net present value commercial projects without combining liquid deposits
and illiquid commercial loans as in traditional banks.
11. Huertas’s (1987) proposal that banks hold marketable assets that are continuously
marked to market is similar. Also see Gorton and Pennacchi (1992).
12. The separation of monetary policy from the private credit market was a primary
intent of the 100 percent reserve plan in the 1930s (Fisher 1935;
Phillips 1994d).
Narrow Banking Reconsidered
40 Public Policy Brief
13. There might be secondary effects on private sector credit. If lenders maintain
some cash reserves to support everyday operations, then more highpowered
money in the system would encourage more lending. This also
assumes that an adequate supply of government debt is available for the payments
system. The lack of government debt posed problems for the National
Banking System and in the debates over the 100 percent reserve plan in the
1930s. However, because of the present large government debt, the issue is
less significant.
14. Spong noted that narrow banks could offer savings accounts, but the returns
would differ little from transactions accounts (Spong 1991, 16). However,
organizations that owned narrow banks would probably be better off offering
mutual fund-like savings instruments through affiliates.
15. For a similar proposal that banks be allowed to hold marketable assets, see
the report by the Brookings Task Force (1989).
16. During the New Deal there were numerous proposals to augment the availability
of credit for the private sector through government intervention. The
Reconstruction Finance Corporation, established under President Hoover,
played an important role in reviving the banking system (Todd 1993). Adolf
Berle and Gardiner Means each advocated that a nationwide system of
credit banks be established, and others had similar proposals (see Phillips
17. The functional approach requires that only monetary service companies
have access to the payments system and that the asset portfolios of narrow
banks be legally separate from any affiliate lending institutions. This is discussed
in more detail below.
18. Pollock (1992b) would only require safe assets to be pledged against demand
deposits with no line of separation beyond this.
19. Under narrow banking the shift out of demand deposits may be no worse
than under the current system and might actually even be lessened.
Disincentives to hold deposits under the current system include the prohibition
of interest on demand deposits, nonearning reserves, deposit insurance
premiums, capital requirements, and regulatory costs—all of which could be
lowered or eliminated with narrow banking. Though narrow banks would
have a limited asset choice, so would any competitors that were seeking to
offer funds on demand without a government safety net to support them.
20. The payments system comprises both the Federal Reserve provided system,
Fedwire, and private payments clearing such as ACH (Automated Clearing
House). The concern is with potential losses to the Fed in the event of a
bank failure before final settlement. However, as more competitors enter
into the payments system, the potential losses to the Fed will likely diminish.
Though the problem may not disappear, its importance as an argument
against narrow banking may decrease.
The Functional Approach to Financial Reform
The Jerome Levy Economics Institute of Bard College 41
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Narrow Banking Reconsidered
48 Public Policy Brief
Ronnie J. Phillips is a research associate of
The Jerome Levy Economics Institute of
Bard College, Annandale-on-Hudson, New
York and professor of economics at
Colorado State University in Fort Collins.
He received a B.A. degree from the
University of Oklahoma in 1973 and a
Ph.D. in economics from The University of
Texas at Austin in 1980. He previously
taught at Texas A&M University at College
Station and has been a visiting scholar in
the Bank Research Division of the Office of
the Comptroller of the Currency. His current
research interests are banking regulation,
financial institutions, and the financial
history of the United States. His articles
have appeared in numerous journals, including
The Journal of International Economics,
Southern Economic Journal, the Journal of
Money, Credit, and Banking, and The Journal
of Post Keynesian Economics. He is the
author of The Chicago Plan and New Deal
Banking Reform (Sharpe, 1994).
About the Author
The Jerome Levy Economics Institute of Bard College 49

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