Is It Finally Time for Narrow Banking?

• Author: Godek, Paul E.
• Position: BRIEFLY NOTED

The idea of narrow banking has been around at least since the Great Depression, which is not a coincidence. Narrow banking, also known as 100 percent reserve banking, stands in opposition to our current system of fractional reserve banking. Given the recent tumult in the U.S. banking sector, along with the uncertain extent of federal deposit insurance, this is a good time to review the merits of narrow banking.

Currently, banks are required to keep only a small fraction of their deposits as "reserves" with the central government bank, the Federal Reserve. Banks are free (though subject to voluminous regulations) to loan out and otherwise invest the rest of their deposits. Hence, the system is known as fractional reserve banking. (The regulations are there to prevent banks from taking excessive risks with depositors' money, which sometimes works, sometimes doesn't, but more on that below.) Narrow banks, in contrast, would keep all deposits at the Federal Reserve or invested in short-term U.S. Treasury bills.

Unstable and hazardous / Banks are said to be in the inherently unstable situation of borrowing short (from depositors, who can withdraw their money at any time) and lending long (to borrowers for mortgages, auto loans, business loans, etc., who pay back the loans over long periods). The inherent instability of this system is on display whenever there is a bank run, or a series of bank runs (also known as a banking crisis or the medical-sounding "systemic contagion"), or even in the perennial Christmas movie It's A Wonderful Life, in which a bank run plays a supporting role.

To reassure depositors and prevent bank runs, the federal government insures bank deposits up to some specified maximum per account. But that still leaves us with at least three problems:

First, deposit insurance encourages banks to take excessive risks with depositors' money because bailouts will happen if too many loans turn sour. Heads the bank wins, tails the federal government bails out depositors. That's where the term "moral hazard" comes in. Economists use the term to describe what happens when you have more insurance than you ought to have, given how insurance can affect your attitude toward risk-taking.

Second, many depositors have balances at banks far greater than the insured maximum. Why would that be? In part, because of the next problem.

Third, the federal government sometimes insures bank deposits beyond the specified maximum, depending on such...