Narrow Banking: An Overdue Reform that Could Solve the Too-Big-To-Fail Problem and Align U.S. And U.K. Regulation of Financial Conglomerates

Abstract

This article is based on testimony presented on December 7, 2011, before the Subcommittee on Financial Institutions and Consumer Protection of the Senate Committee on Banking, Housing, and Urban Affairs. The article provides an update and extension of my previous work showing that: (1) the U.S., U.K. and other developed nations provided enormous subsidies for “too-big-to-fail” (“TBTF”) financial institutions during the financial crisis, thereby creating dangerous distortions in our financial markets and economies; (2) large financial conglomerates follow a hazardous business model that is riddled with conflicts of interest and prone to speculative risk-taking; (3) the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) creates helpful new tools for regulating systemically important financial institutions (“SIFIs”) and dealing with their potential failure, but Dodd-Frank does not completely close the door to government bailouts of creditors of SIFIs; (4) Dodd-Frank relies on the same regulatory techniques – including capital-based regulation and prudential supervision – that failed to prevent the banking and thrift crises of the 1980s and the current financial crisis; and (5) Dodd-Frank also depends on many of the same federal agencies that failed to stop excessive risk-taking by financial institutions during the credit boom that preceded both crises.

In view of Dodd-Frank’s shortcomings, the article reiterates my proposals for more extensive structural reforms and activity limitations that would (i) prevent SIFIs from using federal safety net subsidies to support their capital markets activities, and (ii) make it easier for regulators to separate banks from their nonbank affiliates when financial conglomerates fail. Congress should mandate a pre-funded Orderly Liquidation Fund (“OLF”) and should require all bank and nonbank SIFIs to pay risk-based assessments to the OLF to provide for the future costs of resolving failed SIFIs. Congress should also mandate a “narrow bank” structure for financial conglomerates that would (a) protect the Deposit Insurance Fund from the risks created by nonbank affiliates of SIFI-owned banks, and (b) prevent narrow banks from transferring their FDIC-insured, low-cost funding advantages to their nonbank affiliates. My recommended reforms are similar to the “ring-fencing” proposal issued by the U.K. Independent Commission on Banking and endorsed by the Cameron coalition government. The narrow bank concept provides a promising way for the U.S. and the U.K. to adopt a common approach for regulating financial conglomerates. If the U.S. and the U.K. adopted consistent regimes for controlling the risks posed by SIFIs, they would place great pressure on other developed nations to follow suit.

Keywords: Dodd-Frank, financial conglomerates, narrow banking, orderly liquidation, ring-fencing, safety net subsidies, systemically important financial institutions

JEL Classification: E44, E53, F30, G15, G18, G20, G21, G28, K20, K23