Classical or « Narrow » Banking ?

Greg Mankiw provides today a link to the Wikipedia entry on « narrow banking”. Here is the beginning of it:

“Narrow banking is a proposed type of bank called a narrow bank also called a safe bank. Ultimately, if adopted widely, this could lead to an entirely new banking system. Narrow banks can, by risk reduction measures designed into the narrow bank, significantly reduce potential bank runs and the need for a deposit insurance provided by the central bank. It is sometimes suggested as an improvement upon fractional reserve banking.

Narrow banking would restrict banks to holding liquid and safe government bonds. Loans would instead be made by other financial intermediaries. That is, the deposit taking and payment activities have been separated from financial intermediation activities. Two different types of banks (financial companies) are needed, one for each activity.”

I think that it would be preferable to return to “classical banking” in which banks would still take deposits and make loans, but would not be allowed to invest in other sophisticated financial instruments and seek high levels of leverage. Other financial institutions could include low risk “narrow banks” investing in government or private high grade bonds, but also hedge funds and other types of funds that could invest their depositors’ money in other, more risky, financial assets, conditional on being submitted to a strict regulation of authorized leverage, that whoulod be publicly advertized. For the latter, caveat emptor …

Such a structure – if not an “ideal financial system” – would be closer to what Laurence J. Kotlikoff (Boston university) and Edward Leamer (UCLA) suggest in today’s Forbes magazine, that of a “Limited Purpose Banking” in which all financial institutions would be transformed into many categories of mutual funds, depending on their specialization in the assets they are allowed to buy.

As a side benefit from such a new structure, one should be reminded that the financial literature has shown that diversified firms are inferior in terms of risk-return mix, to specialized ones.