Narrow Banking

Narrow banking is a proposed banking system that would restrict commercial banks to hold only safe and liquid assets, like government bonds, against customer deposits, while prohibiting traditional lending activities. Under this model, banks would function as custodians and payment processors, separate from the lending function performed by other financial intermediaries. The concept emerged as a response to banking instability and gained attention following financial crises, though there is limited implementation.

Narrow banking proposals fundamentally differ from current fractional-reserve practice by eliminating maturity and credit risk. Proponents argue this would enhance financial stability and reduce systemic risk, while critics claim it could reduce credit availability to the economy.

Concept and structure

Narrow banks' business model differs from traditional commercial banks. Instead of borrowing short-term deposits to make long-term loans, narrow banks would back demand deposits with 100% central bank reserves or short-term government securities.

Key characteristics include:

Asset restrictions: Banks would be restricted to holding safe assets like government bonds.

Functional separation: Deposit taking and payment functions would be separated from lending, which would be funded through uninsured deposits and capital. Money market funds might become an important source of finance for households and develop expertise in originating credit.

Fee-based revenue model: Since narrow banks cannot earn income from lending, they would be fee-driven.

Narrow banking contrasts with full-reserve banking, which typically allows banks to make loans using equity capital or time deposits, while backing demand deposits with 100% reserves.

Theoretical foundation

The case for narrow banking draws from financial stability concerns. Proponents argue the inherent instability of fractional-reserve banking arises from the conflict between the promise to convert deposits to cash on demand and the practice of lending most deposited funds.

Banking fragility theory suggests traditional banks are inherently vulnerable to bank runs because of self-fulfilling market concerns about bank liquidity adequacy. Narrow banking would eliminate this fragility by always having liquid assets to meet withdrawal demands.

Risk separation could reduce the need for deposit insurance. Separating the payment system from credit risk protects from losses in lending activities.

Monetary policy could more effective as central banks improve their ability to directly control the money supply process, rather than being influenced by private bank lending.