Tag Archives: FDIC

Narrow Banking: History and Merits

George Pennacchi discusses narrow banking in an article in the Annual Review of Financial Economics. He concludes as follows:

During the nineteenth century, US banks were more narrow than they are today, and the narrowest (e.g., those under the Louisiana Banking Act of 1842) appeared resistant to panics. Common modern-banking practices, such as maturity transformation and explicit loan commitments, arose only after the creation of the Federal Reserve and the FDIC.

… There appears to be little or no benefits available from traditional banks that could not be obtained in a carefully designed narrow bank financial system. Most importantly, a narrow-banking system could have huge advantages in containing moral hazard and reducing the overall risk and required regulation of the financial system.

In contrast, the reaction by US regulators to the recent financial crisis was to expand the government’s safety net by raising deposit insurance limits and by giving more financial firms access to insured deposits. Expanding, rather than narrowing, the activities that are funded with insured deposits is justified if one believes that regulation can contain moral hazard when firms have many, complex risk-taking opportunities. Unfortunately, this belief appears dubious if one recognizes that regulators face political and information constraints.

In my view, there is a need for research that considers the optimal design of a financial system when a government regulator is limited in its ability to assess risk. … Research needs to better identify those financial services where government support would produce a net social benefit. Services such as maturity transformation and liquidity insurance may not deserve costly government guarantees. Finally, should further research support the general concept of narrow banking, there are still open questions regarding the specific features of these banks. In particular, how narrow should be these banks’ assets and should their liabilities should be deposits or equity shares (at fixed or floating NAVs) are questions that need better answers.

Single-Point-Of-Entry, Orderly Liquidation Authority and Chapter 14

In the thirteenth, fourteenth, fifteenth and sixteenth chapters of “Across the Great Divide: New Perspectives on the Financial Crisis,” Randall Guynn, Kenneth Scott, David Skeel and Michael Helfer discuss legal strategies to resolve financial institutions, including single-point-of-entry, orderly liquidation authority under the Dodd-Frank act, or proposals for a new chapter in the bankruptcy code.

Proposed in 2012 by the FDIC, the single-point-of-entry strategy has widely been acknowledged as useful, both in the US and internationally (for example in Switzerland by FINMA). Guynn writes:

The key to solving the TBTF problem without taxpayer-funded bailouts is a high-speed recapitalization of the failed financial group that imposes losses on shareholders and other stakeholders but avoids unnecessary value destruction and preserves the group’s going-concern value. …

The SPOE strategy can be implemented under the existing Bankruptcy Code, although a new Chapter 14 could increase the likelihood of its success, particularly if it were coupled with a secured liquidity facility from the government that would be able to provide such liquidity under the most severe economic conditions.

“How Is the System Safer? What More Is Needed?”

In the ninth chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Martin Baily and Douglas Elliott argue that significant progress has been made in safeguarding financial stability:

  • Due to higher bank capital requirements, the FDIC can intervene before equity is wiped out.
  • Liquidity requirements work in the same direction and render fire sales less likely.
  • Easier resolution of distressed financial institutions helps to shield taxpayers when a bank fails.
  • Better macro prudential oversight helps to manage systemic risks.

The authors discuss these dimensions in much detail.

“How Efforts to Avoid Past Mistakes Created New Ones: Some Lessons from the Causes and Consequences of the Recent Financial Crisis”

In the first chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Sheila Bair and Ricardo Delfin argue that regulatory responses to past crises sow the seeds of the next ones:

  • The “Greenspan put” fostered risk-taking and overconfidence.
  • Low interest rates and the search for yield led to a lowering of lending standards and stronger demand for mortgages; a rise in housing wealth accompanied falling household incomes. The Fed’s strong policy response to the Great Recession may create new risks.
  • The 1980s savings and loans crisis led to stronger reliance on the originate to distribute model and securitisation of mortgages. Market participants lost sight of the risks. Regulatory incentives led banks to take the securitised loans back on their balance sheets and additional sources of maturity mismatch arose from strong reliance on short-term funding.
  • The “self-correcting markets myth” led Congress to deregulate financial services. The Gramm-Leach-Bliley Act fostered competition and consolidation; the Commodity Futures Modernization Act loosened oversight over the OTC derivatives market. Financial regulators also relaxed restrictions; Basel II replaced standardised regulator-set capital charges with internal models of banks.The Dodd-Frank Act reversed this trend, allowing for more discretion and micro-management.
  • The pre-crisis incentives led to large, “too-big-to-fail” institutions and bred moral hazard. Dodd-Frank improve things, by establishing consolidated oversight, living will requirements, enhanced prudential standards and enabling the FDIC to resolve systemic entities that cannot be resolved safely in bankruptcy. Clearing houses may require more regulation.

History of Finance and Financial Regulation

The Economist reviews the history of finance and financial regulation, arguing that

institutions that enhance people’s economic lives, such as central banks, deposit insurance and stock exchanges, are not the products of careful design in calm times, but are cobbled together at the bottom of financial cliffs. Often what starts out as a post-crisis sticking plaster becomes a permanent feature of the system. … The response to a crisis follows a familiar pattern. It starts with blame. New parts of the financial system are vilified: a new type of bank, investor or asset is identified as the culprit and is then banned or regulated out of existence. It ends by entrenching public backing for private markets: other parts of finance deemed essential are given more state support.

The Economist identifies five major events that shaped modern finance:

  • Hamilton’s bank bailout in 1792.
  • The creation of joint-stock banks in England after the “emerging markets” crisis of 1825.
  • The railroad crash of 1857, global panic and the Bank of England’s stricter requirements for discount houses to hold cash.
  • Financial fraud and low cash holdings, the 1907 panic, the National Monetary Commission’s demand for a lender of last resort and the 1913 Federal Reserve Act establishing the (third) central bank in the US.
  • Recession and financial meltdown in 1929, the bank holiday of 1933, publicly funded bank recapitalization, Glass-Steagall and the FDIC.