The Hindu Business Line : ‘Narrow’ banks: An idea whose time has come?

Depositors in ‘narrow’ banks will enjoy full deposit protection. Governments will have no qualms about completely insuring ‘narrow’ banks as their asset portfolios are only in zero-risk assets.

S. Balakrishnan

Some years ago, the concept of a ‘narrow’ bank was widely discussed in policy-making, academic and market circles. One would have thought that in current times when the entire spectrum of commercial banks, investment banks, insurers and hedge funds are in crisis, this institutional model would come to the fore, gain broad support and form part of the solution tool kit. Surprisingly, it has not happened.

What’s a ‘narrow’ bank? It’s a deposit-taking institution like any other bank. But, the resemblance stops there. The ‘narrow’ bank deploys its funds only in completely risk-free assets. (By this it is probably meant those free of credit risk). The only asset satisfying this criterion is Government paper. Owning commodities is subject to the risk of price fluctuation, called market risk.

The quality and characteristics of bank assets can make a world of difference. Any bank tries to make as much money as possible on the spread, i.e., the difference between what it pays for its deposits and the rate it charges borrowers. In the process, it absorbs credit risk, i.e., the possibility that it will not get its money back. The more sophisticated (or the more foolish in today’s context) try to increase profits by borrowing short-term and lending long-term, as long-term interest rates are invariably less than short rates. This creates a cash flow mismatch. Liabilities mature before assets, subjecting the bank to liquidity risk.

How could they? The banking business is predicated on the assumption that not all depositors will ask for their money at the same time and minor cash flow gaps can be easily managed with market borrowing.

Confidence

At the bottom of it all is confidence. As long as it stays, banks can enjoy the spreads and actually make money out of mismatches. When confidence collapses, the bottom falls out.

Hence, the brainwave that banks could be segregated into ‘narrow’ and ‘broad’ banks. The latter will be allowed to invest in a variety of assets. In other words, ‘broad’ banks will have far more lending and investment freedom.

Obviously, ‘broad’ banks and their deposit customers would not enjoy the same privileges. Such banks would be similar to non-banking financial companies. Their asset and activity profile would be riskier. Levels of deposit insurance and central bank liquidity support would also be restricted.

‘Narrow’ banks may offer complete safety but deposit rates would be low. Deposit and lending rates would be higher in ‘broad’ banks, matching their risk profile.

It’s an idea whose time has come. A reformed financial sector and a new regulatory framework for banks must have a place for ‘narrow’ banks.

Related Stories:
Verma Committee report - New ways to appraise banks
Beyond monetary arithmetic

More Stories on : Banking | Financial Markets | Financial Scan

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page