How to Avoid the Next Taxpayer Bailout of the Financial System: The Narrow Banking Proposal

Abstract

As recovery from the present economic crisis begins, policymakers must address what reforms will be made in financial system in order to prevent the reoccurrence of a similar crisis in the future. What will Congress do in response? In terms of long-term financial reform, what is to be expected from Congress is passage of legislation that increases oversight and regulation by the federal financial regulatory agencies. The purpose of this policy brief is to explain and evaluate one proposal for reform of the financial system that would help mitigate the policy conundrum that often results from conflicting short-run and long-run policies. This proposal, known as “narrow banking,” would separately regulate and supervise the role of banks in providing a safe and stable means of payment from the system of credit creation by financial institutions. The heart of the proposal is to make checkable deposits as safe a means of payment as currency presently issued by the Federal Reserve System, but without the need for the elaborate supervisory and regulatory structure required when federal deposit insurance and the discount window are part of the financial safety net.

Keywords: banking regulation, narrow banks, financial crisis

JEL Classification: G21, G28, E51