The Economist on Narrow Banks - Cochrane

The Economist on Narrow Banks

The Economists Free Exchange blog covers narrow banks, and parts of my "run free" paper in a post somewhat mean-spiritedly -- or perhaps unintentionally self-descriptively --  titled "Narrow Minded." I always appreciate publicity, but a few parts seem wrong enough to address.

After nicely covering the history of the idea, the Economist writes,

such a plan raises huge practical questions. The first is implementation: how to get from today’s system of highly indebted banks to one in which they are financed chiefly by equity. 

That's not hard. We're slowly raising capital requirements, and all we have to do is to keep raising them. My Pigouvian tax on debt would help a lot -- I think banks screaming how hard it is to issue equity or how terrible not to pay dividends for a while would suddenly find it much easier if paying 5 cents for each dollar of debt issued. Announcing that institutions above 50% equity and with less than 20% short-term debt are exempt from Basel and Dodd-Frank asset regulation might cause a rush for the exits.

Politically, there would be formidable opposition from vested interests. 

And this is, somehow, an argument against the plan rather than for it? There is formidable opposition from vested interests against abolishing agricultural subsidies, trade protection, occupational licensing, and taxicab monopolies. Dear Economist, when did feeding the cronies become an argument for keeping bad policy in place, not a main indicator of needed change?

Economically, the transition would require banks to dispose of a vast stock of loans, or raise an equivalent amount of long-term debt and equity.

The first is simply untrue, and the second is deeply misleading. For every dollar of long term debt or equity that must be raised, one dollar of short term debt is paid back. No extra funds from investors are required, and no selling of assets is required. It's just a Modigliani-Miller / Yogi Berra reslicing of the same pizza.

A second concern is whether a split between narrow banks and wider lending-and-investment firms would actually eliminate runs. If other institutions replace banks in making loans, they could end up creating fragilities of their own. Mutual funds, for example, are financed by shareholders, not creditors; but if such shares are seen as stable and safe, investors will treat them as deposits—and try to withdraw their investment if that safety is threatened.

This is just simply wrong, and in the "Economist should know better" camp. You cannot "withdraw your investment" from a floating-value  fund.  The fund makes no fixed-value promises. It cannot fail. It cannot suffer a run. Look up the definition of run, dear Economist! A floating-value fund, and especially an exchange-traded fund with no one-day NAV promise,  is the paradigmatic example of a run-proof institution.

Yes, investors can all try to dump stocks, either held directly or held through funds, and stock prices can go down. There is no failure, no bankruptcy, and no crisis in this. We want a system that allows booms and busts without crises, not the promise that wise regulators will step in to stabilize stock prices!

After this happened even once, people would simply flock to the narrow banks, and there would be no source of lending.” To prevent this, the authors argue, governments would have to intervene to save the “not-so-narrow intermediaries”.

Now we're deep into the silly season. The intermediaries do not need any saving. They have not made any promises. A floating value fund cannot go bankrupt! Yes, stock prices can fall, and your fire sale is my buying opportunity. Do we really want Governments and their central banks buying stocks to prop up their values? Do we really want governments allocating credit? Have we so lost sight of what a "crisis" is, and is not?

Third, such a system would still need plenty of regulation.

The fact that we need some regulation -- that I don't produce a libertarian-anarchist nirvana solution in which absolutely zero regulation is required -- is somehow a defense of the current monstrous setup? I think we need cops at stoplights. Is this a defense of Dodd-Frank? Come now, it takes about 1/10th the regulation, because we can throw out all regulation of the safety of bank asssets, all the risk weights, all the stress tests, all the "resolution," and so on. The perfect is truly the enemy of the good at the Economist.

But given the growing cost and inefficiency of today’s regulatory regime, the concept of narrow banking surely deserves more serious consideration.

I'll take the grudging endorsement and return a grudging gratitude for the mention of the idea!