Narrow Banking Reconsidered the Functional Approach to Financial Reform

No. 17

Posted: 11 Feb 1997  

Ronnie J. Phillips

Colorado State University

Date Written: Undated


Ronnie J. Phillips presents the functional approach to reform for the financial system. This approach advocates the separation of the depository and lending functions of banks. As a result of the structural separation of banks' functions, monetary and credit policy undergo a parallel separation, and government supervision and regulation of the banking industry is modified. The policy prescription developed within this approach is narrow banking, the creation of separate monetary and financial service companies with the elimination of or substantial reduction in deposit insurance. Phillips asserts that narrow banking not only meets the safety and soundness goals of bank regulation, but also maintains an institutional structure that accommodates market forces and technological innovation. Phillips reviews the history of government involvement in the payments system. He traces the notion of backing demand deposits with federal government securities (a notion that is endorsed by the functional approach) to the early monetary system of the American colonies and to the National Banking Acts of 1863 and 1864. These acts guaranteed that the Treasury would redeem notes issued by national banks and backed by government bonds at par value. Although the currency was backed by government debt, it was not until the Emergency Banking Act of 1933 that the means of payment was backed by federal government debt. Two years later the Banking Act of 1935 created federal deposit insurance. The functional approach maintains that insurance dulls the incentives of depositors to seek a depository institution with sound assets and the incentives of depository institutions to maintain liquidity and high asset quality. Opposing this view are those who support fractional reserve banking, in which commercial banks hold central bank liabilities against their own liabilities. This approach contends that banks perform a valuable service through their dual functions of depository and lending activity and that this system yields efficiency gains because of information symmetries and the ability to hold minimal cash balances. Supporters of fractional reserve banking argue for reform through instituting risk-based pricing of deposit insurance, using subordinated debt to monitor banks' lending activities, having depositors pay fees for insurance, and increasing capital requirements. Narrow banking advocates argue that the microeconomic efficiency benefits of the fractional reserve banking reforms do not outweigh the macroeconomic costs. In the fractional reserve system the Federal Reserve is able to encourage credit restraint more easily than credit growth. In the functional system the Fed retains a significant role in monetary policy and a modified role in credit policy. One goal of the functional approach is to mitigate the influence of monetary policy on the credit market. Therefore, in its system monetary policy affects only those institutions, known as monetary service companies, holding liabilities backed by government debt. In other words, monetary policy is not simultaneously credit policy, as it is today. The portfolios of monetary service companies offering demand deposits would be restricted to only "safe" assets. The underlying assumption of the narrow bank policy is that the primary function of banks is to provide a payment mechanism. Phillips describes several narrow bank proposals that vary in their definitions of safe assets. However, as the interpretation of safe assets broadens, additional safety features are linked to the proposals. Complementing the monetary service companies are financial service companies, where savings are channeled to investors. Within this financial structure, financial holding companies may own both types of service companies, but the assets of the narrow bank remain separate from other financial units of the holding company. Establishing separate monetary and financial service companies enhances the safety of the payments system, improves the ability of the Fed to control monetary aggregates, reduces government regulation of banks, accommodates the growth of mutual funds, and eliminates or significantly reduces deposit insurance. Phillips discusses a number of issues raised by critics of narrow banking: the availability of safe assets and the corresponding maturities of these assets; the availability and cost of funds, especially for small businesses and consumers; access to the payments system; the shrinkage of the size of the banking system; the potential difficulty with overdrafts; foreign banking operations; and the political feasibility of the functional approach. Phillips recommends the adoption of two specific financial system reform proposals. first, he endorses the creation of monetary service companies that would serve strictly a payments function and would hold only safe assets, as prescribed by Robert E. Litan and James L. Pierce. Second, he recommends the proposal of James R. Barth and R. Dan Brumbaugh, Jr., that the federal government establish a mutual fund that holds only government securities as assets.

JEL Classification: G20

Suggested Citation

Phillips, Ronnie J., Narrow Banking Reconsidered the Functional Approach to Financial Reform (Undated). No. 17. Available at SSRN:

Ronnie J. Phillips (Contact Author)

Colorado State University ( email )

Fort Collins, CO 80523-1771
United States


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