Limited Purpose Banking?

October 4, 2010

by Jerry O’Driscoll  

The following is a book review from the Cato Journal, Vol. 30, No. 3 (Fall 2010).  

Jimmy Stewart Is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking Laurence J. Kotlikoff      (Hoboken, N.J.: John Wiley & Sons, 2010, 241 pp.)  

Chapter 1 of the book is titled “It’s a Horrible Mess,” and in it Laurence Kotlikoff, a professor of economics at Boston University, reminds the reader of the breadth, depth, and horror of the global financial crisis. It is a cure for the dispassionate observer of events, an indictment that would send all but those with ice water in their veins to sign up for the Tea Party Express. The book is a particularly well-written account of the crisis that begins in housing finance, spreads throughout the financial system, and then throughout the real economy. The crisis hit in tsunami-like waves beginning in 2007 and continued into 2009.  

In Kotlikoff’s words, “We thought we had well-functioning banking and insurance companies with competent directors, world-class managers, responsible regulators, and incorruptible rating companies. But overnight, we it learned it was a sham.”  

The theme that financial capitalism was a sham runs throughout the book. He asks and answers in the affirmative whether Wall Street is running a Ponzi scheme. Russ Roberts, an economics professor at George Mason University, has reached the same conclusion, and similar indictments have been made across the political spectrum. Former Fed chairman Paul Volcker has suggested much of what occurs on Wall Street involves moving economic rents around without creating economic value. In short, Kotlikoff echoes the opinion of many observers.  

Other themes include both the perfidy and sheer incompetence of those who ran major financial institutions, the failures of the regulatory apparatus, and the haplessness and confliction of those directing financial policy.  

Kotlikoff employs a journalistic style, but underlying the account is the analytic mind of a first-rate economist. He is eclectic in his theoretical approach, telling the reader “I’m neither a Keynesian nor a monetarist,” but I believe in the possibility of “multiple equilibria associated with coordination failures.”  

As the subtitle suggests, the analysis of the crisis is a prelude to a proposal for reform: limited purpose banking. LPB is a variant of narrow banking. He expands on traditional narrow banking proposals in two dimensions, and thereby moves to a much broader financial reform.

Traditional banking is a debt-based system in which banks borrow money from the public in the form of deposits. Bankers keep only a portion of the borrowed funds in the form of cash or reserves, and lend the rest out. As banker George Bailey (played by Jimmy Stewart in It’s a Wonderful Life) had to explain to his angry depositors, their money was not really in the bank but on loan to their neighbors. The system is called one of fractional reserves.  

Over the centuries, bankers learned to forecast normal cash demand and kept cash reserves on hand (or in correspondent banks, and later central banks). The smart ones kept a little extra. Fractional reserve banking works in normal times, but is prone to break down in times of financial stress when most or all banks face extraordinary demands for cash.  

In the United States, the weaknesses of fractional reserve banking  were compounded by an artificial system (in many states) of a large number of small, unitary banks (one office). Local economic downturns would sour the loans of such banks, lowering the value of their assets, and increase cash demands as stressed borrowers drew on their bank deposits to meet expenses. The system of small banks with fractional reserves made them prone to bank runs and failure. It is that combination that explains the appeal of narrow banking in the U.S. context.  

These problems were long recognized, and the onslaught of the Great Depression brought proposals for banking reform. Economists at the University of Chicago put forth the Chicago Plan in 1933, and Yale Economist Irving Fisher proposed his own system of 100 percent money in 1935. Though plans differed in details, the essential idea was to separate banking into two parts. The payments system was protected by requiring 100 percent reserves against transaction or checking accounts (demand deposits) in a narrow bank. Reserves would comprise vault cash plus deposits by commercial banks at their local Federal Reserve Bank. Traditional bank lending would be separated from risky investment banking.  

Milton Friedman was a notable exponent of narrow banking, and he updated the Chicago Plan in A Program for Monetary Stability (1960). In 2009, Ronnie J. Phillips and Alessandro Roselli further updated the proposal in a policy brief entitled “How to Avoid the Next Taxpayer Bailout of the Financial System: The Narrow Banking Proposal.”  

Such plans were considered but rejected in the 1930s in favor of retaining fractional reserve banking and unit banks, and adding deposit insurance to forestall bank runs. That adherence to the status quo ensured an unsafe banking system and periodic bailouts.

Many banking economists believe that deposit insurance could have been avoided and banking stability achieved by moving to nationwide branch banking—a scheme that sustained the Canadian banking system through the Great Depression and the recent financial crisis.  

The wonder is that it has taken so long for a serious reconsideration of narrow banking. Though at some pains to distance his plan from earlier proposals, Kotlikoff builds on those models. He goes considerably beyond them, however, in two important dimensions.

First, he includes all financial institutions in his plan. Previous narrow banking plans shared a common problem. Nonbank financial firms would have an incentive to issue close substitutes for demand deposits to compete with the restricted narrow banks. These nonbanks could offer higher yield on such substitutes because of the riskier, higher-yielding assets they would hold on their balance sheets. In its modern form, that is the problem of shadow banking. Even in the 1930s the problem was recognized. Chicago School economist Henry Simons wanted to limit all forms of short-term credit.  

Kotlikoff’s second innovation may be bolder than the first. He wants to switch from debt-based banking and finance to an equity-based system. At the level of the financial firms (banks and all others), all financial activity would take place through mutual funds. Financial firms could not leverage themselves by borrowing money. Banks would not suffer losses or book gains on their activities, though their customers would.  

Banks would offer mutual funds comprising assets of various categories, duration and risk. They would be only intermediaries in doing so, and would more resemble a mutual-fund family like Fidelity than a modern bank. One such fund would be a cash mutual fund and would most resemble the narrow bank. Thus, as Kotlikoff emphasizes, narrow banking is but an element of his proposed total transformation of the financial system.  

Kotlikoff tells the reader upfront that he comes to the issue not as a specialist, but with the freshness of an outsider. That brings its advantages, but on this second, far-reaching aspect of his reform proposal it brings problems. He appears unaware of the large and contentious literature on equity banking; certainly he cites none of it.  

His proposal invokes the contributions of Fischer Black, Eugene Fama, and Robert Hall—the so-called BFH system. Their proposal for mutual-fund banking was perhaps most ably advanced by Robert Greenfield and Leland Yeager. It has been criticized by, among others, Lawrence H. White and myself. A good deal of the debate occurred in the pages of the Cato Journal. In short, Kotlikoff has prodded an intellectual hornet’s nest with his proposal.  

Without reviewing the many contentious (and sometimes technical) issues involved, I will raise one serious and practical one. There has been no observed tendency for equity banking to crowd out debt banking. Quite the contrary. White has argued that par-valued debtclaim notes and deposits have historically evolved as media of exchange instead of mutual fund shares. He attributes that evolutionary dominance to lower transaction and information costs.

In proposing reforms, one should attend to what has actually worked historically and evolved as the result of market forces. Kotlikoff correctly attributes the problem of existing banking arrangements to the ability of banks and other financial institutions to leverage not just their own money but the taxpayers’. That is because governments routinely bail out creditors of these over-leveraged institutions. The response surely should be to end bailouts, not leverage. The fact that, under existing public policy, banks overleverage does not imply that zero-leverage is the preferred outcome.  

The breathtaking changes required of the existing financial system to move to LPB are illustrated by Kotlikoff’s plan to break up Citigroup to conform to the new model. Nothing less than a kind of robust and unprecedented antitrust policy would be required.

All the problems mentioned thus far pale in comparison to what I consider the Achilles heel of Kotlikoff’s proposal. Almost in passing, he proposes a single, overarching regulator of financial services: the Federal Financial Authority. It would take over the functions of all existing financial services regulators and then add to that portfolio.  

Just consider FFAs role in the mortgage market, as a hypothetical borrower, Robby seeks a loan. “The FFA would verify Robby’s income statement using federal income tax returns; it would certify his credit rating; it would verify, using independent local appraisers, the value of the home he intends to purchase; it would verify the property taxes and insurance costs on the home; and it would specify all other pertinent information that would help a mutual fund understand the value of buying Robby’s mortgage.”  

Suffice it to say that the FFA makes LPB a nonstarter on grounds too numerous to catalog in a review. Let me just clarify, however, what the FFA would be in reality: a super-SEC. Kotlikoff wants the FFA to do for the entire financial services industry what the SEC is supposed to do for the securities industry. The SEC is the poster child for failed financial services regulation , and justifiably so.

Kotlikoff details some of its notable failings, particularly the Madoff case. I can understand the desire for a new acronym, but changing the name will not change the substance.  

Kotlikoff excels at detailing the failings of the existing regulatory structure, but does not explain why his proposed system would work any better. If the regulators at the FFA face the same incentives as do those at the SEC (and the rest of Washington’s alphabet soup panoply of regulators), then we should expect the same outcome.

Government regulation, no matter the industry, typically fails for two reasons. First, there is the Hayekian knowledge problem. The information needed for effective regulation is dispersed across firms, the industry, and even the economy. There is no effective means for marshaling and centralizing the information within the agency.  

Second, regulators are routinely captured by the industry they regulate. Through frequent interaction with members of the industry, regulators come to identify with the industry’s interests over thepublic’s. The revolving door between industry and government exacerbates that problem.  

These two factors go a long way to explain the SECs sorry record, and help explain why Kotlikoff’s idea for an FFA is so ill-conceived. It might very well be the case that LPB could be run without an FFA, but not as Kotlikoff has designed it.  

There is a great deal to recommend this book. First, there is Kotlikoff’s recounting of the crisis itself. Second, there is sense of the manifest injustice of a system in which bad actors get to gamble with other people’s money. Third, there is the challenge to do something radical to reform a system that is radically dysfunctional.  

Kotlikoff has performed a service by challenging the existing institutional structure. As I have suggested, he can make common cause with many other economists of divergent political persuasions. James Buchanan has made what may be the strongest argument for 100 percent reserve banking in his article “The Constitutionalization of Money,” which recently appeared in the Cato Journal. He observes that the economic case for fractional reserve banking was to economize on reserves in a commodity money system. Commodity money is costly to produce. Not so fiat money. “The central logic of leverage banking, of any sort, is absent under the operation of a pure fiat money system.”  

Whether the case for narrow banking can finally be convincingly made remains to be seen. The case for mutual-fund banking is a giant leap beyond that. The FFA would, I predict, create an even more horrible mess than yet witnessed in financial services.  

Gerald P. O’Driscoll Jr. (Cato Institute)

16 Responses to “Limited Purpose Banking?”

  1. Pietro M. Says:

    I ordered the book the last week on Amazon. Seems interesting.

    Also Reihnart and Rogoff’s book was good, I read it when I was at the FEE seminar this August.

    Thanks.

  2. Walker Todd Says:

    I commend Jerry O’Driscoll’s review above. Also, the insight he attributes to Buchanan at the end seems right to me, having 20 years’ experience dealing with asset quality and collateral issues at commercial banks while serving as a discount window lawyer at Federal Reserve Banks, including New York. The main rationale for fractional reserves is the economic expansion and comparative cheapness of credit that becomes possible with fractional reserves. But if there is no gold in the system in the first place, then it would seem easy (as the Federal Reserve recently proved with all its Section 13[3] creation of reserves since the spring of 2008) to top up the system with as many reserves as are desired if the only reserves are fiat currency, interbank deposits, government debt instruments, and selected private sector assets (see the traditional types of collateral that were taken before the 1991 amendments of Section 13 [3]). In a fiat currency regime, why is the alleged scarcity of reserves an obstacle to fighting a panic? Indeed, one concludes that, with no gold in the system, a 100 percent reserves system is the only way to go to restrain the expansionary phase (see what tended to happen in the US banking system, 1994-2007) to prevent panics and politically driven demands for costly bailouts over time. Narrow banking is the justifiable and justified regime if there is no gold in the system to exert a restraining influence. Free banking is the optimal regime if there is gold in the system. And either system can be run without a central bank. — Walker Todd, AIER

  3. Lawrence H. White Says:

    An excellent review. Like Greenfield-Yeager, who wanted to eliminate base money because base money has negatives (never mind the positives), Kotlikoff wants to outlaw debt-based banking because debt-based banking has negatives in the context of deposit insurance and implicit guarantees backstopped by central banking and fiat money(never mind the positives in a world without those distortions).

  4. Richard Ebeling Says:

    It seems to me that any “new thinking” about institutional reform about the banking and financial system, has to begin with the tried and true fundamentals. That is, what is financial and banking intermediation supposed to perform in a market economy?

    We want a system that facilitates individuals who wish to save (but who do not want to directly invest themselves) in their ability to find willing and “credit worthy” borrowers.

    If we accept the inescapably and constraint of scarcity, then we also want a system that tends to limit the lending of “money” to the availability of “real” resources not being applied for more immediate consumption uses.

    And there must be some institutional mechanism for the system as a whole that also tends to match the intertemporal savings choices of income earners with the investment planning horizons of those borrowing the saved real resources of the society.

    And there needs to be some distinction between short-term cash balance holdings to facilitate expenditures during the income period (demand deposits, and other related accounts) from long-terms savings balances at banking and other financial institutions; so as not to get into Jimmy Stewart’s banking problem in “It’s a Wonderful Life.”

    Richard Ebeling


  5. Thanks, Walker and Larry. So we agree on free banking plus gold. What will we talk about at Cato’s monetary conference?

    I hope Cato or AIER (or jointly) do another transition to gold conference.

  6. Roger Koppl Says:

    Greenfield and Yeager should never have described their system as one that somehow did not have money. Even the “separation” of medium of exchange and unit of account is not much of a separation.

    Think of a toy version of their system. Gold is the unit of account. Silver is the medium of redemption. A bank note entitles you as much silver as you can trade for two 2 grams of gold on a specified exchange. It entitles you to silver worth 2 grams of gold. The medium of exchange is the bank note, which is always worth 2 grams of gold, i.e., one unit of the unit of account. Not much “separation” between the unit of account and medium of exchange. Now, the toy system probably has no advantages over a straight gold standard. A run on the banks, for example, would threaten their liquidity as silver reserves dwindle. It would be better if banks have a larger range of redemption media. Similarly, changes in the real value of gold will have system-wide effects. It would be better to have a basket of goods as the medium of account. A wisely chosen basket will give the medium of account more stability of value than gold.

    The system is a *monetary* system run along familiar principles, with the prospect of adverse clearings discouraging overissue. It would certainly be an improvement over the “scruffy dollar bill” and I don’t really see where it has any particular infirmities. It is not somehow floating on air as circularity critics have charges.

  7. Lee Kelly Says:

    What Larry said. But add on the problem of using base money for currency, which creates disequilibrium almost every time the composition of money demand (between deposits and currency) changes.

    Also what Roger said, particularl this: “It would be better to have a basket of goods as the medium of account. A wisely chosen basket will give the medium of account more stability of value than gold.”

    Is there some great argument about how this cannot work? Because I have rarely seen it mentioned, but it seems like the most sensible solution to monetary disequilibrium being caused by changes in the supply and demand for base money.

    I always recall Hayek once remarking that in a competitive market for money, the money which maintained a relatively stable average exhange ratio would be preferred. That claim used to puzzle me, especially with a chorus of Austrians calling for deflation in one form or another. But it makes more sense to me now. given this consumer preference, it seems that free banks would have an incentive to discover a mix of assets that would help maintain the purasing power of their monetary unit.

  8. Corrigan Says:

    You gentlemen might want to take a look at the Cobden Center in the UK (www. cobdencentre.org ) where the goal is to revisit the original Peel banking reforms of the 1840s and to put right what was then misconstrued in the attempt to limit fractional reserve banking-led boom-and-bust.

    Aside from the didactic purpose of the group, it has even managed to have a Private Member’s Bill introduced into the Parliamentary process, advocating some far reaching (if, for reasons of pragmatism, very incomplete) banking reform proposals

  9. Bogdan Enache Says:

    Leaving aside all problems of substance, I hate to point out that I think there’s practically no banker who will support narrow banking of some sort, just like there’s practically no politician or high government official who would support abolishing central banking. The status quo of banking architecture is a very robust equilibrium, so to speak.


  10. I agree with Jerry and Lawrence. However this is not likely to be established.

    Alternatively, as a second best, one could at least try to denationalize monetary policy. The current devaluation rally might be an incentive to do so and in fact there are politicians that see a problem of the beggar-thy-neighbor policies.

    I think of a system in which every economy symmetrically (not like in Bretton Woods) stabilizes its exchange rate against some some value (maybe a basket of currencies) at the IMF. This would at least limit power of politics to mess with the economy.


  11. I agree with Andreas in spirit.

    Hayek’s denationalization plan was to allow every person to contract in any national currency (and the contracts to be enforceable). That negates legal tender laws, and it would be a radical step toward monetary freedom.

    Friends in Mexico have advocated that Mexico begin re-issuing silver dollars. (It was their currency to begin with.) That would be a good start.

    Canadian silver dollars used to circulate within the northern border states. When I grew up, Canadian paper dollars were accepted at par in NYC. (They were worth $1.06 on the wholesale market.)

    Let’s restore monetary freedom. Crimp the Fed’s monopoly from the north and south.

    I hope the Irish decouple from the euro and restore the punt. Let the Greeks get back the drachma and, best of all, the Germans their mark.

    Vive la concurrence!


  12. Jerry, Thanks for your thoughtful and very kind review. Let me respond to your concerns about Limited Purpose Banking. You say there is no evidence that we are moving to equity based banking. I’d say there is plenty of evidence. The mutual fund industry represents roughly one third of the financial sector. In 1940 it was hardly noticeable. You suggest that the SEC can’t shoot straight so, therefore, the Federal Financial Authority (FFA) won’t shoot straight either. With all due respect, you are missing a key point. The FFA will have many fewer things to do than the SEC. Also, it will hire competing private firms to perform its very limited set of tasks. I was not aware of the literature you cited on equity banking. I’ll take a look. I think your view that we should stop bailouts, not restrict leverage, has been tried and failed in practice. Lehman was that experiment. Now we’ve been told and seen in practice that no large financial institution will be allowed to fail. You say that the bankers won’t like Limited Purpose Banking. I agree. But they aren’t going to like what’s coming with Dodd-Frank either. You say it’s very complicated to take, say, a Citigroup and turn it into a Limited Purpose Bank, i.e., a mutual fund company. I think it’s very simple and explain how it can be down almost overnight with no major disruption to the financial system. Citigroup’s investment banking is just made a consulting business. That’s very easy to do. Citigroup’s trading business becomes a matching business, not a risk taking business. Citigroup’s checking accounts are turned in cash mutual funds. Citigroup pays out as dividends over time the net income it earns on existing assets less existing liabilities. But it never borrows another dime. Voila, you’re done and there is never again the prospect of Citigroup or, indeed, any bank or financial corporation going bankrupt.

    All best, Larry


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