John Kay and Martin Wolf join the Classical Banking Club

After providing some easy excuses for bank managers (see my July 8, “Narrow Banking and John Kay” post) John Kay has joined the Classical Banking Club that I created on this blog (“Classical or Narrow Banking?”, April 24) by publishing a pamphlet for the London-based Centre for the Study of Financial Innovation, titled "Narrow Banking: The reform of banking regulation".

Martin Wolf now does the same in the Financial Times (“Why narrow banking is not the finance solution”, September 29), although he criticizes Kay for not considering the risk that would remain in the “quasi-banks” that would still be allowed to invest in long-term and risky assets on “wafer thin equity” and short term borrowing.

He prefers the more complete proposal of Laurence Kotlikoff (Boston University) that was favorably commented upon on this blog (“The Classical Banking Club: Further suggestions”, May 14). For Kotlikoff and co-authors, all financial firms should be organized according to the principle of “limited purpose banking”, in which no leverage would be authorized and assets should be both specialized and matched by a same amount of equity -- and not by short term deposits. That equity would be borne by investors in these funds, who would thus be supposed to know the risks they would accept, as all shareholders are supposed to do. The possible failure of such funds would not endanger depositors in the much less risky “classical banks”, and would thus not choke the payment and credit system, nor coerce in that way the financial authorities into salvaging them.

The conclusion of Kotlikoff and co-author Goodman (The New Republic, May 14) is still valid however: “Bankers will likely fight this reform tooth and nail” and, I would add, would divert attention by suggesting new regulation instead.

Martin Wolf concludes on a somewhat more optimistic note: “The authorities will not entertain such radical ideas right now. But the financial system is so inherently fragile that radical reform cannot be pronounced dead. It is only dormant”.