Pennacchi on Narrow Banking

I stumbled across this nice article, "Narrow Banking" by George Pennacchi. The first part has a informative capsule history of U.S. banking.

George defines a spectrum of "narrow" banks. For example he includes prime money market funds -- borrow money, promise fixed value instant withdrawal, buy Greek bank commercial paper. But that is "narrower" than traditional lending, as the assets are short term and usually marketable.

Some interesting tidbits:

Prior to the twentieth century, British and American commercial banks lent almost exclusively for short maturities. Primarily, loans financed working capital and provided trade credit for borrowers who were expected to obtain cash for repayment in the near future

Therefore,

... the typical structure of these early banks contrasts with the modern view of banks, according to which the received wisdom is that “[t]he principal function of a bank is that of maturity transformation---coming from the fact that lenders prefer deposits to be of a shorter maturity than borrowers, who typically require loans for longer periods” (Noeth & Sengupta 2011, p.8)....maturity transformation was often considered a violation of prudent banking.

On the nature of assets:

Following the US Civil War, many banks ... invested in commercial paper... With the establishment of the Federal Reserve System in 1913, commercial paper became especially desired because it was eligible collateral for borrowing from the Fed’s Discount Window. According to Foulke (1931), prior to the 1930s, banks and trust companies held more than 99% of commercial paper....In contrast, banks today hold very little commercial paper

so "bank" then = "prime money market fund" today -- but, after 1913, with discount window liquidity support. Some disintermediation makes a lot of sense. In 1830, you could not hope to sell commerical paper in 10 milliseconds on an electronic exchange, so the "liquidity creation" by banks was more necessary.  The struggles the SEC is having with prime funds today has deep roots.

Credit lines:

One credit service of banks that is ubiquitous today but was completely absent from banks in the nineteenth and early-twentieth centuries was the loan commitment. In recent years, more than 70% of business lending was from loan-commitment drawdowns.

This was an especially interesting issue in the crisis. Chari,  Christiano, and Kehoe noticed bank lending going up in fall 2008. Lending freeze, what lending freeze?  Scharfstein and Ivashina argued increased lending was mostly companies grabbing cash promised under existing lines of credit.

Prior to the 1930s, banks often had long-term relationships with particular borrowers: Banks would lend repeatedly for short terms to the same borrower....During the financial panic period of 1857--1858, the [Black River] Bank’s number of borrowers declined by nearly 75%,..early banks made virtually no formal loan commitments.

so rolling over loans without commitment is a way to preserve the option not to lend in a crisis. Perhaps Fed liquidity support is what changed rolling over to promising to do so.

Narrow deposit creation and the viability of equity-backed banking:

...[the] Louisiana Banking Act of 1842. ...required a bank to hold specie (gold) and bills of exchange and promissory notes maturing in 90 days or less in amounts at least equal to its deposits and notes issued. Moreover, the ratio of specie to the total of deposits plus notes had to be at least one-third. The bank could make loans with maturities greater than 90 days, such as mortgages, and hold real estate and other fixed assets but they must be funded with equity capital, not deposits or notes.

Hammond (1957, p.683) states, “The available evidence is that the system operated with distinguished success…Although the banks of New Orleans were well known throughout the country for their strength and integrity, the law governing them was not generally emulated.” Sumner (1896, pp. 387, 389) is more enthusiastic, calling the act “the most remarkable law to regulate banks, which was produced in this period, in any State…"

We seem doomed to constantly reinvent the steam engine, then to forget how it worked.

In summary, prior to the early-twentieth century, many US banks functioned similarly to narrow banks by holding primarily short-maturity assets to match their short maturity liabilities. Despite the several episodes of banking panics, it may be argued that panics occurred primarily at banks that deviated from the narrow-banking ideal. 

A new kind of moral hazard:

A more important response to the 1907 panic was the establishment in 1913 of a government lender of last resort and central bank in the form of the Federal Reserve System. Access to the Fed’s Discount Window made it less costly for banks to hold longer-term and more illiquid loans. Indeed, Friedman & Schwartz (1963) argue that the Fed’s existence changed banks’ behavior in ways that led to more bank failures during the early 1930s. Banks shifted to higher credit-risk loans and felt less need to lend to each other during times of stress because that was now considered the Fed’s responsibility (which the Fed failed to perform adequately).

...bank capital-asset ratios were trending downward since the 1840s (when they were over 50%), but the decline accelerated following the founding of the Fed and the FDIC. The capital ratio then stabilized in the range of 6%–8% starting in the early 1940s

and half of that at the start of the financial crisis in 2007.

As with other proposed bank reforms, recommendations for narrow banks appear most frequently following major financial crises. With the exception of the Louisiana Banking Act of 1842, and possibly the U.S. Postal Savings System, proposals involving narrow banks have not been implemented.

Well, not yet!

The rest of the paper has a nice summary of narrow banking proposals, and theoretical analysis.