Minsky and the Narrow Banking Proposal: No Solution for Financial Reform

by Guest Author Jan Kregel, Levy Economic Institute

Introduction

The recent losses at JPMorgan Chase, the money laundering activities of HSBC, and the recent discovery of collusive activity to influence the London Interbank Offered Rate by the money market desks of some of the largest global banks, some two years after the adoption of the Dodd-Frank Act, have led to calls for a more rigorous approach to the regulation of large multifunction banks that are clearly too big to manage and too big to regulate.

Pictured is Hyman Minsky (1919-1996).

One response has been to suggest a simple breakup of the largest banks.  Both the president of the Federal Reserve Bank of Dallas, Richard Fisher (2012), and the former president of the Federal Reserve Bank of Kansas City, Thomas Hoenig (2009), have formally proposed the dissolution of the largest complex US financial institutions that dominate the financial system. But this proposal deals only with the size of financial institutions; it does not indicate what the structure of the smaller institutions should be. Creating a greater number of smaller, independent financial holding companies would not necessarily simplify supervision if these companies were still dealing in multiple types of complex, interconnected financing activities involving structured lending instruments. Simply making institutions smaller need not make them safer and more stable, if they are permitted the same range of activities involving the same types of financial instruments. And in the absence of effective antitrust legislation, breaking up the larger institutions would in all likelihood simply be followed by another process of concentration by merger and acquisition similar to that seen after the suspension of branching restrictions.

In reponse to this problem, others have suggested a return to a regulatory framework closer to the Glass-Steagall Act’s separation of the commercial and investment banking functions of finance in different legal institutions. As Hyman Minsky noted, one little-appreciated benefit of the 1933 act was that

“the scope of permissible activities by a depository institution was to be limited to what examiners and supervisors could readily understand…    It was not so much the differences and riskiness as it was the ease of understanding the operations that led to the separation of investment and commercial banking” (Minsky 1995a, 5).

In other words, Glass-Steagall’s limits on the size and activities of financial institutions should make it easier for regulators, supervisors, and examiners to understand and monitor institutions’ operations.

In his considerations of possible improvements in the structure of the financial system, Minsky suggested that the benefits of simplicity and transparency inherent in Glass-Steagall might be preserved within a bank holding company structure by restricting the permissible assets and liabilities of the separate subsidiaries.  In a number of documents prepared for the mid-1990s discussions of the reform of Glass-Steagall, Minsky proposed,

One or more subsidiaries of a post Glass-Steagall bank holding company will have monetary liabilities. These subsidiary institutions will enjoy protections from the central bank and treasury which guarantee that their monetary liabilities will not fall to a discount from their face value. . . . In exchange for this protection the assets they can own will be restricted. A representative post Glass Steagall bank holding company will have specialized financial subsidiaries which include not only a combination of commercial, investment and merchant banking subsidiaries but also a sampling of more specialized financial institutions such as credit card operations, payment operations, finance companies and the brokering and underwriting of insurance. Each subsidiary will have a dedicated equity, which protects the holders of the liabilities of the subsidiary. (Minsky 1995c, 3)

Minsky drew out the implications of such a system:

“once the distinction between the payments and financing operations of banks is recognized, it follows that post Glass Steagall banking firms will be structured as bank holding companies in which the payments subsidiary is clearly separated from the financing subsidiaries.  In exchange for this protection the assets of the payments subsidiary will be limited to government debt and interest earning accounts at the Federal Reserve: the assets of the payments banks will not include business and household liabilities”  (10–11).

Thus, the

“holding company structure of post Glass Steagall banking [would] quite naturally lead to 100% money” (12).

But such proposals are not new. The National Banking Act was based on government liabilities backing the issue of national banknotes. It was also an integral part of Henry Simons’ “Positive Program for Laissez Faire” (1934) and supported by Irving Fisher (1935).  It was revived by Milton Friedman (1959),
and was part of formal reform proposals made by James Tobin (1987) and Robert Litan (1987), among others, in the 1980s discussions of bank reform, as well as by Ronnie Phillips (1995).

As the failings of Dodd-Frank become more and more obvious, these proposals have again become part of the active discussion of regulatory reforms.

In this approach, a single subsidiary would be dedicated to the provision of deposit-taking transactions services, while other subsidiaries would provide investment and merchant banking services. If all subsidiaries were sufficiently and separately capitalized, it is argued that there could be no problem of “bailing out” speculative activities to save the payments system, there would be no possibility of using customer deposits for proprietary trading and speculation, and, with appropriate balance sheet restrictions on the transactions subsidiary, even the moral hazard created by deposit insurance could be eliminated.

Minsky’s “vision” of the economic system and “narrow banking”

For Minsky, it was the fact that “development financing involves taking risks”

…that created the need for “a regulatory and supervising authority for the financial system that accepts that financing development opens the system to losses that have the potential for adversely affecting the safety and security of the economy’s payment facilities. To allow for this possibility the regulators need to try to insulate the payments system from the consequences of such losses. The problem therefore is to provide for protection of the payments system from the consequences of the losses which may ensue from development financing” (Minsky 1994, 10–11).

As a result, Minsky characterized the role of the financial system as servant to two mutually conflicted masters:

“…any capitalist banking and financing system is “drawn between two masters” that it “needs to serve: one master requires assurance that the financing needed for the capital development of the economy will be forthcoming and the second master requires assurance that a safe and secure payments mechanism will be provided.”

It is clear that Minsky considered the narrow bank proposal as a way for the financial system to meet its basic objectives of financing the capital development of the economy and providing a safe and secure payments system by insuring that

“the payments and the financing of the capital development of the economy functions will therefor[e] be separated in a post Glass Steagall banking structure” (Minsky 1995c, 8).

Minsky’s adaptation of the Simons/Fisher proposal may thus be seen as an attempt to ensure financial stability by separating financial institutions by function, or “master,” so that each would serve only one master. Banks that provide payment services can be made perfectly safe and secure by requiring 100 percent reserves in government currency and coin or other risk-free government liabilities.¹

The financing of the capital development of the economy would then take place via retained earnings of corporations or by means of investors’ conscriptions committed to financing specific private business activities.  Organized and supervised as an investment “trust,” such an institution would have a 100 percent ratio of capital to assets and thus should not be considered a threat to the financial stability of the economic system.

The most important implication of this proposal is that in such a perfectly separated, dual system there would be neither a deposit-credit multiplier, nor leverage, nor creation of liquidity.  This point was raised in the context of the Diamond-Dybvig model of the existence of banking by Neil Wallace (1996), who interpreted “the narrow banking proposal as one requiring the banking system to be liquid without any reliance on liabilities subordinate to deposits,” and concluded that “the narrow banking proposal eliminates the banking system” (7–8).

However, there is another drawback of the proposal that was not raised in the mid-1990s discussion and is even more relevant in today’s political environment. The proposal would create a financial system that would respect Hayek’s idea of “neutral” money, in which all investment decisions are the consequence of the voluntary savings decisions of individuals. The Wicksellian alternative formulation of this condition is the equality of the nominal rate of interest and the “real” rate of return on investment.

The idea of this approach was to eliminate any “monetary” disturbances to equilibrium in the “real” economy so that savings determine loanable funds available for investment.

While a financial system that was regulated via a 100 percent reserve requirement on deposits and a 100 percent ratio of capital to assets for investment trusts would then appear to resolve the conflicting objectives noted by Minsky, such a system could neither ensure the stability of the real economy nor assure stability of the capital financing institutions. First, the real investments chosen could still fail to produce the anticipated rate of return; and second, sectoral overinvestment and financial bubbles could still exist if there were herding behavior by the investment advisers of the trusts that produced procyclical financing behavior. There would always be a risk of investors calling on the government to save them from financial ruin.²