Western banking may be returning
to the traditional deposit-based banking of Thailand 

Banking in western countries like the US, UK, and Europe may be soon returning to its traditional roots.

Some emerging market economies have adopted western financial innovations over the last decade (Read article).

Thailand compared to most countries, even in Asia, has remained conservative and focused on traditional deposit funded banking after the 1997 crisis.

Today's article discusses how western banks may have to put aside their financial innovations and return to traditional deposit-based banking.

The following short article is part of a free ebook published by VoxEU that contains articles by leading international economists (Read ebook).

The articles were prepared for the important G20 conference being held this weekend in Washington on the global financial crisis (See previous article).

Returning to narrow banking

Paul De Grauwe
University of Leuven and CEPR
From: What G20 leaders must do to stabilise our economy and fix the financial system

Bubbles and crashes have been part of financial markets for centuries. Allowing banks - which inevitably borrow short and lend long - to get deeply involved in financial markets is a recipe for disaster. The solution is to restrict banks to traditional, narrow banking with traditional oversight and guarantees while requiring firms operating in financial markets to more closely match the average maturities of their assets and liabilities.


There can be no doubt that a reform of the international financial system is necessary
to avoid future crises. However, the G-20 meeting should also avoid an agenda that
takes on too many problems. The leaders need to focus on the essential problem – the
international banking crisis and the factors that led to this crisis.

Banks inherent instability

It is useful to start from the basics. Banks are in the business of borrowing short and
lending long. In doing so they provide an essential service to the rest of us, i.e. they
create credit that allows the real economy to grow and expand. This credit-creation
service, however, is based on an inherently fragile system. If the banks’ depositors or
lenders are gripped by collective distrust and all decide they want their money back,
bank will go broke; the money is not there since the deposits were invested in illiquid
assets. This is how a liquidity crisis erupts, setting in motion a devilish cycle of
insolvency and new liquidity crises.

Repeal of stability regulation

We learned from the Great Depression that in order to avoid such crises we have to
limit risk taking by bankers.

We unlearned this lesson during the 1980s and 1990s when the banking sector was
progressively deregulated, thus giving banks opportunities to seek high risk investments.
The culmination of this deregulatory movement was the repeal of the Glass-Steagall Act
in 1999 under the Clinton Administration. This ended the separation of
the commercial and investment banking activities in the US – a separation that had
been in place since the 1930s banking collapse. Repeal of the Glass-Steagall Act
opened the gates for US banks to take on the full panoply of risky assets (securities,
derivatives and structured products) either directly on their balance sheets or indirectly
through off-balance sheet conduits.


Similar processes of deregulation occurred elsewhere, in particular in Europe, blurring
the distinction between investment and commercial banks, and in the process
creating "universal banks". It now appears that this deregulatory process has sown the
seeds of instability in the banking system.

The critical lack of a firebreak

Financial markets have, for centuries, been gripped by speculative fevers that have led
to bubbles and crashes; bubbles and crashes are an endemic feature of financial markets.
But financial market problems do not automatically affect banks. In the most
recent crisis, bubbles and crashes would not have been a major problem had banks
not been involved so deeply in financial markets. Banking sector deregulation, which
started in the 1980s, is what exposed the banks so catastrophically to the speculative
dynamics inherent in financial markets. Banks’ balance sheets became the mirror
images of bubbles and crashes occurring in the financial markets. An explosive cocktail
of credit and liquidity risks was created that was waiting to explode.

The failed Basel approach

The Basel approach to stabilise the banking system is based on an attempt to model
the risks universal banks take and to compute the required capital ratios that will
minimise this risk. Such an approach is unworkable. The risks that matter for universal
banks are "tail risks", i.e. events which are extremely rare but which cause extremely
large losses – like AIG’s near bankruptcy, or Lehman being allowed to go broke.
Such risks cannot be accurately modelled (a key element of the Basel approach) precisely
because they are so rare.

The only workable approach to ensuring bank stability

This leaves only one workable approach. This is a return to narrow banking in which
the range of activities in which banks are allowed to engage is narrowly circumscribed.
In this approach banks are excluded from investing in equities, derivatives
and complex structured products. Investment in such products can only be performed
by financial institutions, e.g. investment banks, which are then forbidden
from funding these investments by deposits (either obtained from the public or other
commercial banks).


In a nutshell a return to narrow banking could be implemented as follows:

* Financial institutions would be forced to choose between the status of a
commercial bank and that of investment bank.

* Only the commercial banks would be allowed to attract deposits from the public
and from other commercial banks and to transform these into a loan portfolio
with a longer maturity (duration).

* Commercial banks would benefit from the lender of last resort facility and
deposit insurance, and would be subject to the normal bank supervision and
regulation.

* [Non-banks] The other financial institutions that do not opt for a commercial bank status
would have to ensure that the duration of their liabilities is on average at least
as long as the duration of their assets.

This last point would imply, for example, that they would not be allowed to finance
their illiquid assets by short-term credit lines from commercial banks.

International coordination to avoid a classic, regulatory race-to-the-bottom

A return to narrow banking can only occur if it is embedded in an international agreement.
This is where the G-20 comes into the picture.

When only one or a few countries return to narrow banking, the banks of these
countries will face a competitive disadvantage. They will lose market shares to banks
less tightly regulated – a result that would produce forceful lobby against the restrictions.


In the end, the governments of these countries will yield and the whole process
of deregulation will start again.

A comprehensive international agreement will be necessary to remodel banking
systems and to separate commercial banks from investment banking activities. This
is what a Bretton Woods II conference should focus on.

Clearly there are other desirable reforms, such as improving the incentive structures
of bank managers and rating agencies, and a better representation of emerging
countries in the IMF. The focus of Bretton Woods II, however, should be to reform the
banking system so that it does not get involved in bubbles and crashes that are
endemic to financial markets.

Posted by Jon Fernquest at 06:02 PM | Permalink | Comments (0)