Ultimately the “correct solution” to the US’s banking troubles are not going to come from a simple return to narrow banking or a switch to macro-prudential banking either. While macro-prudential banking looks in its early stages to be working in Columbia and Spain, it has no proven success in an advanced economy to this point, and its reliance on data and data analysis is fairly dangerous. While of course new is not always “bad,” when dealing with the American economy I think it is essential to start off with a system that has been proven to work soundly, and then implement smaller reforms on this system to make the system work even better. Research has shown that macro-prudential analyses were unable to detect the subprime crisis because it was not the “common bank crisis”. Additionally, there is always a tendency for the authorities and those conducting the analyses to get caught up in the same sort of optimism as the private sector, and this could be especially prevalent in a society as driven by wealth as the US’s. On the other hand, simply narrow banking (completely separating commercial and investment banks) has been shown to be restrictive on both the commercial and investment sector and would thus lower potential economic growth. The “too big to fail” proposal, while it has many positive aspects, really seems like an answer to only part of the problem.
The top solution I believe will take aspects from all three, and the banking solution I propose does this to some degree. Narrow banking- when done correctly- has worked very well in the past for the American economy: From post-WWII up through the late 90’s, the US was essentially void of any long (1+ year) recessions, outside of those due to extreme jumps in oil prices (rise in OPEC oil prices in 1973 along with Vietnam spending and also 1981 with jump in oil prices due to the Iranian Revolution). This was while following a strict narrow banking strategy as imposed by the Glass Steagall Act. As a reference, prior to the implementation of narrow banking there were over 10 recessions of 1+ year in the US in the previous 100 years (including a number that lasted over 2 years). With less enforcement of the act in the 1990s and finally the repeal of it in 1999, investment banks quickly began playing the role of commercial banks and taking on deposits, and commercial banks began selling off their deposits as investments. Quickly this led to the worst financial crisis in the US since the Great Depression. However, it is important to remember that while the financial crisis did emerge from the mixing of banking roles, extreme economic growth occurred initially. The best solution should seek to embrace this economic growth while preventing large financial crises that can stagnate it. My proposal plans to follow a “less narrow” form of narrow banking that will be less restrictive on banks while keeping a closer eye on their actions, less reliant on data analysis, but prevent the devaluing of assets from bringing down the entire financial institution, thus keeping the number of 1+ year recessions at a minimum.
– The first reform to implement is a simple restriction on the size financial institutions are allowed to grow to relative to the whole system. When one bank gets too intertwined in the affairs of all other banks and is essentially “too large to fail,” this can be a huge problem and have market-wide implications. Restrictions on the percentage of market assets held by any one financial institution need to be implemented to prevent the dependency of an entire economy on this single institution. Banks will still be able to continue growing, just not at a significantly faster rate than the rest, and this will essentially eliminate any sort of monopolization inside the banking sector. While this can eliminate the possibility for economies of scale, it will also prevent them from making risky decisions, knowing that the government will be forced to bail them out if they do indeed fail.
– A clear distinction must be made between investment banking and commercial banking, just as with the Glass Steagall Act. Investment banks must be in no case allowed to take on deposits of their own. Commercial banks must be restricted from selling off their deposits as assets, outside of Prime, low risk mortgages. Requiring commercial banks to hold onto all but the most risk-free mortgages will as an incentive for them to not let the mortgages default. They will only give out mortgages to credit-worthy customers if they must bear the burden of a default. In my proposed strategy, all assets would fall under 3 “tiers” according to their riskiness. Tier 1 would include low risk highly liquid assets, tier 2 less liquid and more risky assets, and tier 3 the highest risk and least liquid assets. The basics of each tier are outlined in the table below:
Tier 1 MMMFs, Treasury Bills, Certificates of Deposit, Gov’t Bonds, Euro debt securities
Tier 2 Corporate Bonds, Preference shares
Tier 3 Debentures, Corporate stocks, credit card debt, derivitives, triple A securities (rated by Fed)
– In this proposed model, investment banks would be allowed to invest in all 3 tiers. During times of market efficiency/stability, commercial banks would be limited to investing in tier 1 assets. Close regulation of the financial system (as in macro-prudential banking), would be put into place by the Fed to closely monitor market-wide risk, and based on this risk commercial banks would be permitted to invest in Medium risk (tier 2) assets depending on the financial conditions- during times of recession tier 2 assets will become available for commercial investment, and during booms the availability of investment in these assets would close off. But because in this model investment banking and commercial banking will be largely separate, a failure of the Fed to correctly predict the risk in the market will not result in a possible crisis as in pure macro-prudential economy.