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The case for narrow banking

April 19th, 2012

Here’s my first post under the new approach to blogging I’m trying. It’s the intro to an article I just published in The National Interest. They ran it under the headline “The Next Global Collapse” which is a bit more dramatic than the article itself. The deal with TNI is that I can published the first three paras here, to tease your interest. Thinking about how best to work this, it struck me that it would be really great if readers here would follow the link, comment on the article at TNI, then repost their comments here. Perhaps this might just be duplication, but it might also lead to quite different conversations. So, please give it a try

Four years after the near-meltdown of the global financial system, the world is no closer to an adequate system of financial regulation than it was in 2008. Attempts to regulate the market for derivatives have been stymied by a mixture of determined resistance from the industry and the technical difficulties of defining and regulating such complex and opaque financial instruments. The “shadow-banking” system, associated with investment banks, hedge funds and other speculative financial institutions, is as large and dangerous as ever.

Right now, the only thing preventing a new bubble and bust is the memory of the last one. And with the return of massive profits and bonuses to Wall Street, that memory is fading fast. Already, observers are noticing a renewed appetite for risk, fueled in part by the low returns available on relatively safe investments such as U.S. Treasuries.

As in most unwinnable wars, the time has come when the best option is, in the immortal words of Republican senator George Aiken (speaking of Vietnam) to declare victory and get out. But what does getting out mean, as far as the shadow-banking system is concerned?

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  1. Freelander
    April 19th, 2012 at 19:05 | #1

    Yes. The case for narrow banking is very strong. Ordinary banking is very much a commodity business. If a bank only loaned depositers money on homes, well insured and having twenty percent deposit margins could be slim,depositers, could sleep sound in their beds and bonuses would be a thing of the past.

    The government should use its postal network to set up a narrow bank and watch customers leave the big four.

  2. Freelander
    April 19th, 2012 at 19:09 | #2

    Declaring victory and getting out. I like it! And hadn’t heard it before!

  3. e-girl
    April 19th, 2012 at 20:47 | #3

    Aren’t those things called building societies and credit unions?

  4. Freelander
    April 19th, 2012 at 21:20 | #4

    @e-girl

    Not really. They also rely heavily on banks to function , have a problem because of their small scale and governance structure s .

  5. April 19th, 2012 at 21:51 | #5

    On the form not the substance of this post.

    I thought you were going to require a right to cross-post with your “new approach”. This post falls short of that. Of course if you join a team you must abide by team rules but I cannot help but think that something is lost – even if the team effort gets higher readership.

    I wonder why National Interest only give you 3 paras. Their site is open access anyway. An instance of the mafia-monopolist principle?

  6. rog
    April 19th, 2012 at 21:51 | #6

    The distinction is the between banks as being places where financial transactions occur and places where money (in the form of debt) is created.

  7. Chris Warren
    April 19th, 2012 at 22:39 | #7

    @Freelander

    The government should use its postal network to set up a narrow bank and watch customers leave the big four.

    Unfortunately Australia Post is a Government Business Enterprise so this possibility is lost.

    Capitalism has set up such a political structure (competition policy, free trade, fiscal equalisation) that any Government narrow banking initiative will be easily fenced in by mainstream capitalism.

    Also it seems that narrow banking does not really address the problem of:

    a mixture of determined resistance from the industry and the technical difficulties of defining and regulating such complex and opaque financial instruments.

    .

    Some of these instruments may have a purpose outside capitalism. It may therefore be preferable to look for some broader form of co-operative banking based on credit unions so that any benefits from bona fide financial innovation can be maintained. Loanable funds and tactics for insurance are critical needs for all forms of economics.

    Narrow banking proposals appear to propogate the myth that it is only some bad behaviour within capitalism, or loose structure within, that is the problem – not capitalism itself. In essense narrow banking is the sort of thing I would expect from British Fabians who are crying for “a different sort of capitalism” [www.fabians.org.uk/publications/publications-news/labour-must-do-more-on-the-economic-alternative].

  8. Chris Warren
    April 19th, 2012 at 22:40 | #8

    @Freelander

    The government should use its postal network to set up a narrow bank and watch customers leave the big four.

    Unfortunately Australia Post is a Government Business Enterprise so this possibility is lost.

    Capitalism has set up such a political structure (competition policy, free trade, fiscal equalisation) that any Government narrow banking initiative will be easily fenced in by mainstream capitalism.

    Also it seems that narrow banking does not really address the problem of:

    a mixture of determined resistance from the industry and the technical difficulties of defining and regulating such complex and opaque financial instruments.

    .

    Some of these instruments may have a purpose outside capitalism. It may therefore be preferable to look for some broader form of co-operative banking based on credit unions so that any benefits from bona fide financial innovation can be maintained. Loanable funds and tactics for insurance are critical needs for all forms of economics.

    Narrow banking proposals appear to propogate the myth that it is only some bad behaviour within capitalism, or loose structure within, that is the problem – not capitalism itself. In essense narrow banking is the sort of thing I would expect from British Fabians who are crying for “a different sort of capitalism” [www.fabians.org.uk/publications/publications-news/labour-must-do-more-on-the-economic-alternative].

  9. April 20th, 2012 at 00:28 | #9

    I clicked through to the article. It’s free.

    I wouldn’t do that if (a) it wasn’t free: (b) it was in any way owned or controlled by Murdoch; (c) there was a convoluted ‘sign in’ process.

    If they make money from ‘clicks’ in those circumstances (and how is that so different from buying a paper and not buying a product from each and every advertiser in the paper?), then this could be a workable model in my view.

    The decline of ad revenue in printed ‘news’ papers is most likely due to the fact that they, in Murdoch’s case especially, sold out their readers in order to push an extreme ideological viewpoint on the one hand, and on the other screwed their advertisers by lying about the impact and effectiveness of buying ads.

    Wherever possible I make a point of not buying any product from any business which heavily finances Murdoch’s hate media.

    In a ‘free’ society I’m able to do that.

    On the other hand, I like to go out of my way to support businesses who avoid the hate media and advertise with the independent media. I know might makes right, but I don’t care. Anyone who supports people who hack dead children’s phones for nothing more than commercial gain deserves to be sanctioned.

    There is a reason why we use the word “unforgiveable” to describe certain behaviour. It is because it can NEVER be forgiven. EVER. Under any circumstances.

  10. Ikonoclast
    April 20th, 2012 at 03:12 | #10

    JQ writes, in part;

    “However, the rescue effort crippled the capacity of central banks to manage the economy and caused grave damage to the finances of the governments concerned.”

    I know an article like that has a word limit but this is asserted with no support. How has the rescue effort “crippled the capacity of central banks to manage the economy and caused grave damage to the finances of the governments concerned”? This sound like hyperbole to me. Governments pretend they can’t act when they could indeed do so.

  11. Ikonoclast
    April 20th, 2012 at 03:18 | #11

    I should add, I agree with narrow banking. However, the reform of the system must go much further than that. Endless growth and capitalism per se are both unsustainable.

  12. Freelander
    April 20th, 2012 at 04:17 | #12

    hc :
    … I wonder why National Interest only give you 3 paras. Their site is open access anyway. An instance of the mafia-monopolist principle?

    They want to feed traffic through so they can see if they can sell any of their wares. Just like most retailers. They call it capitalism.

    Ikonoclast :
    JQ writes, in part;
    “However, the rescue effort crippled the capacity of central banks to manage the economy and caused grave damage to the finances of the governments concerned.”
    I know an article like that has a word limit but this is asserted with no support. How has the rescue effort “crippled the capacity of central banks to manage the economy and caused grave damage to the finances of the governments concerned”? This sound like hyperbole to me. Governments pretend they can’t act when they could indeed do so.

    Seems fair comment by JQ. I can’t speak for his explanation of his reasoning but it seems to me that central banks’ capacity to address domestic concerns has been considerably hampered both by the need to consider what is and may happen internationally, and therefore to keep their ‘powder dry’, and by the liquidity trap that has been created both due to the lowering of interest rates and by businesses and consumers shock after the GFC and consequent reduced willingness to spend. When you have to swerve your car to avoid a hazard, other considerations, like conserving your tires from wear and tear, suddenly become secondary.

  13. Freelander
    April 20th, 2012 at 04:18 | #13

    moderation?

  14. Ikonoclast
    April 20th, 2012 at 07:32 | #14

    I also want to comment on;

    “The government should use its postal network to set up a narrow bank and watch customers leave the big four.” – Freelander.

    Once upon a time, Australia had a publicly owned “narrow bank”. It was called the Commonwealth Bank. Re-nationalise the Commonwealth Bank, Australia Post, Telstra and all water and power infrastructure. All of them were better run, provided a better service and were of better value and common-wealth to the people when they were state owned. Prices of water and power (for example) were far cheaper comparitive to wages than they are today. Privatisation has been outright theft of the peole’s wealth in common. Education should also be free and public at all levels. And all state subsidies to private business (which subsidies are currently massive and in the billions) should cease. The capitalists are the real free-loaders. The nation should stop subsidising them.

  15. Freelander
    April 20th, 2012 at 08:27 | #15

    @Ikonoclast

    Yes. Agreed. Selling the CBA was a big mistake along with many other sales and ‘reforms’.

    Ignoring the benefit from using the CBA as a real competitor to keep the other banks honest, and also the improved policy options straight after the GFC of being able to administratively order the CBA to not tighten credit to business, particularly small business, the sale was without doubt a financial disaster. I am sure that the debt retired and the associated stream of interest liability would have been much smaller than the stream of payments the government would have received if the bank had been retained and operated as it has been post share sale. That would be an interesting exercise for someone to do – a cost of lost ownership against the saving in retired debt using the returns the CBA has provided since its sale. The same exercise could be done with the others. The only case where a sale would have possible been a winner for government would be with Telstra. However in the case of Telstra, it would have been an apparent financial winner, but a net loser for the economy due to the reduced policy flexibility government suffered, and Telstra’s anti-competitive tactics, especially dragging its feet rolling out broadband (which has necessitated radical policy like the NBN).

  16. Sam
    April 20th, 2012 at 11:56 | #16

    The only worry I can see here, is the part where we put our hand on our heart and vow never to bail out non-narrow investment institutions. Given your point in the last paragraph about the political power of financial lobbyists, it would be hard to make this credible.

  17. Jim Rose
    April 20th, 2012 at 21:32 | #17

    Ed Prescott also supports narrow banking.

    Kareken and Wallace predict that if a government sets up deposit insurance and doesn’t regulate bank portfolios to prevent them from taking too much risk, the government is setting the stage for a financial crisis. the Kareken-Wallace moral hazard model makes you very cautious about lender-of-last-resort facilities and very sensitive to risk-taking by banks.

    the Bryant-Diamond-Dybvig adverse selection model has been very influential generally, and in particular that it was very influential in 2008 among policymakers.

    The Diamond-Dybvig and Bryant model makes you very sensitive to bank runs because without deposit insurance, the economy is very vulnerable to bank runs, and they are very optimistic about the ability of deposit insurance to prevent them at no cost.

    HT: Tom Sargent

  18. BilB
    April 22nd, 2012 at 07:04 | #18

    This weeks quotable quote

    “Right now, the only thing preventing a new bubble and bust is the memory of the last one.”

  19. Mitchell Porter
    April 22nd, 2012 at 12:36 | #19

    “But what does getting out mean, as far as the shadow-banking system is concerned?”

    For a lot of countries it’s going to mean, cutting back financial ties with America and Europe.

    The central new force is BRIC as geopolitical bloc, and the immediate catalyst is the western attempt to sanction Iran and anyone who does business with Iran, which is instead hastening the construction of a set of economic relations which simply route around America and Europe and their political dictates.

  20. Declan
    April 23rd, 2012 at 13:40 | #20

    I thought Friedman/Tobin ‘narrow banking’ was 100% reserves, ie complete separation of deposit taking & long term lending.

  21. Chris Warren
    April 24th, 2012 at 10:43 | #21

    While narrow banking has its appeal (depending on the detail) a broader approach to the regulating the Finance Sector should also be considered. I would support a publicly-owned bank where it is ‘entrenched’ in Law that it is not profit-making. The ACT has suitable entrenching provisions.

    The real problem is not “ownership” but “profit-expectations”.

    This is from the SEARCH Foundation – [http://www.search.org.au/projects/global-crisis-fact-sheets/global-crisis-fact-sheet-6-financial-regulation].

    create a genuine publicly-owned bank which will be willing to lend to creditworthy customers in all sectors – rural, industrial, commercial, services, housing. nationalise any Australian bank that collapses, but don’t bail out shareholders.

    run publicly-owned banks by boards which include professional financial experts, government representatives, and also representatives of community sector organisations and elected staff representatives on a charter to serve the public interest.

    regulate finance sector executive salary packages, using the Corporations Power of the Federal Constitution – the same power used for the Fair Work Act.

    sharply reduce international financial speculation by imposing a tax of 0.1 per cent on all financial transactions – a modified ‘Tobin Tax’ – to regulate the whole finance sector, and to help fund international aid to poor countries. This requires international agreement.

    stop regulated banks and financial institutions from lending for ‘derivatives’ unrelated to the real economy, and to hedge funds; no bailouts for these speculators.

    legally separate auditors from accountants and banks. Auditing regulations must include criminal penalties for non-compliance. Big accounting and auditing firms have been declaring shonky business operations as ‘sound’, because of the huge fees they are paid.

    fix currency exchange rates against a new global standard – not gold, not the US dollar, not the Euro, but a new global currency proposed by the United Nations Expert Panel.

    support international moves to make the Credit Ratings Agencies – Standard & Poors, Moodys, and Fitch – independent of the companies which they rate. If these moves go nowhere, then nationalise the ratings agencies in Australia. The Ratings Agencies declared that the ‘mortgage-backed securities’ from the USA were ‘triple A’ when in fact they were worthless – because they were paid hefty fees by the banks to promote them.

  22. April 27th, 2012 at 02:34 | #22

    Ikonoclast, I think you will find the interview of Ellen Brown from the US Public Banking Interest by James Corbett of last November most interesting. It contains a lot of interesting research into the early history of Banking in Australia in the late 19th Century and early 20th century by Ellen Brown. It can be found here on Global Research TV and is also embedded in the web-site I contribute to linked to above.

    Professor Quiggin, It seems to me that the easiest solution to the monetary and finance crises we face is the re-establishment of proper Public Banking as advocated by the US Public Banking Institute. Can you see any flaws in their argument?

  23. Glenn Condell
    April 29th, 2012 at 12:15 | #23

    Great to see this topic gaining traction, and also to see Ellen Brown’s name mentioned. I have been reading her for several years and her push for public banking a la Bank of North Dakota or the old Commonwealth forms one plank of my reform wishlist, and Chris Warren’s list from SEARCH contains many of the others. Money created for the kinds of civic purposes such institutions are chartered to fund is not inflationary, especially if the banker canker is removed from the aorta of credit creation, where it has been sitting with it’s huge maw over the spigot, eating a hundred year long free lunch.

    I would only add:
    embed trustworthy paper-trail elections (for the US, we still have this thank God);
    publicly fund all elections to public office, no private or corporate or union contributions permitted;
    either outlaw derivatives and other ‘innovations’ or set up an official trading desk for them, or make it clear that claims originating outside of the regulatory structure cannot be legally enforced
    allow private financial companies to fail with no government bailout, unless they agree to several items – (a) public equity commensurate with rescue funds, (b) board representation reflecting public pre-eminence, (c) a program to increase employee share ownership to an agreed target within agreed timeframe, (d) the highest paid officer or employee to receive no more than an agreed multiple (say 25) of the lowest paid employee, (e) employees who make money recommending particular investments to clients the weight of which meets some agreed level of monetary importance must have a commensurate component of their own remuneration formed by such investments.

    It would be good too if the discipline of Economics could somehow be officially obliged to don sackcloth and ashes, with a Minsky/Godley/Keen emphasis righting that listing ship but I guess that is out of scope for such a list of do-ables for now, along with the advent of a class of politicians and parties not so instantly beholden to the power elites du jour. I would even go for the Keen debt jubilee where savers are rewarded along with the peons, but then I’m all for world peace too.

  24. Jim Rose
    April 29th, 2012 at 15:06 | #24

    john,
    You hit the nail on the head when you asked “But what does getting out mean, as far as the shadow-banking system is concerned”

    No banking regulation to encourage depositor vigilance and diversification is not time-consistent. More regulation outside of the banking sector will be undone by innovation.

    Narrow banking would just encourage innovation. The often unstable building societies and credit unions were a response pre-1983 bank regulation in oz.

    If you do find the answer, enjoy your new career as a fabulously well-paid international consultant.

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