Narrow banking

This is an old article, going back to 1998, which I thought became relevant with some suggestions for narrow banking coming up here and there.

Narrow banks or safe banks are those whose assets are required to be invested only in safe and liquid government bonds. This was proposed as an option for weak banks in India by the Committee on Capital Account Convertibility, chaired by S.S. Tarapore, former Deputy Governor of the Reserve Bank of India, in the year 1997. My comment on this recommendation was published in the Op-Ed page of Economic Times dated 24 April 1998. In view of the general nature of discussion having relevance for policy makers across the world, its continuing relevance, and the fact that it is not available in soft copy form even on the website of the Economic Times, it is reproduced here.

Postscript: Let me express my thanks and gratitude to Late M.S. Aradhye, a true professional and thorough gentleman, who was my General Manager (he retired as one) at the Reserve Bank of India’s Byculla Office, for giving me permission to publish this article. Remember, it was a time when it was not easy for an RBI insider and that too a very junior functionary like me to publish an article critical of someone like S.S. Tarapore, former Deputy Governor. It is a measure of Tarapore’s greatness that instead of feeling any animosity, he sent word through a common friend in then Department of Economic Analysis and Policy that he quite liked the article, and that it contained many valid points. I don’t think he wrote again arguing for narrow banking as an option for weak banks, definitely not in his subsequent Report on Fuller Convertibility (2006). How this article was a first step in what eventually brought me closer to Tarapore, and resulted in a friendship that lasted till his death, is a story for another date. For the time being, please read on…

Narrow Banking: Banking Too Narrowly (as published in April 1998)

The Tarapore Committee’s recommendation to convert weak banks into narrow banks appears to be a case of attacking the symptom rather than the disease.

“Narrow banks” may be defined as banks which place their funds only in short-term, risk-free assets. Alternatively, they may also be banks whose demand deposits are matched by safe, liquid assets. In some proposals, these banks have sole access to deposit insurance as well as to the payment system. Such banks are expected to remove the problems of bank failure and the consequent systemic risks and loss to depositors. It is hoped that it would thus obviate the need for deposit insurance, other safety net measures and even bank supervision.

The role for narrow banks as envisaged by the committee differs mainly in the context in which the suggestion is made. The committee has proposed that “the incremental resources of these narrow banks should be restricted only to investments in government securities and, in extreme cases of weakness, not only should such banks not be allowed to increase their advances but there would need to be a severe restraint on their liability growth”. In other words, the incremental SLR (statutory liquidity ratio) of weak banks is sought to be increased to 100 per cent and for ‘extreme cases’, a cap on both advances and deposits is to be introduced.

Suggestions that banks match the maturities of their assets and liabilities have been made by Adam Smith in the 18th century. In the 1950s, Milton Friedman had proposed that banks maintain 100 per cent reserves as a means to provide monetary stability and free the banking system from regulation. In the 1970s, a proposal to confine riskier activities in related firms under a holding company structure while the no-risky narrow banking would be carried out separately was mooted as an alternative model for implementing universal banking.

The concept was discussed widely in the late 1980s and early ’90s in the context of the bankruptcy of the Federal Savings and Loans Insurance Corporation in the USA, following the failure of a large number of insured institutions in the ‘savings and loan crisis’. The term ‘narrow banking’ was introduced to refer to institutions whose assets would be confined to low-risk assets. Confining deposit insurance to such institutions would reduce the burden on the insuring bodies and remove the problem of moral hazard on account of such insurance which is believed to have been one of the major factors contributing to the crisis. Viewed against the foregoing, the committee’s suggestion to introduce narrow banking as a safer route for specific weak banks appears to be unique.

Narrow banking, in its purest form, does not seem to exist anywhere. In India, when the pre-empted resources of banks (both CRR and SLR) were in excess of 50 per cent of total liabilities, the banking system as a whole (both weak and strong ones) went more than half the way towards narrow banking.

The assumption underlying the committee’s suggestion seems to be that further lending by weak banks can only add to their woes. Therefore, alternatives in the form of further capitalisation or creation of an asset reconstruction fund for resolution of bad loans do not find favour. Neither do merger or other ways of exit. This assumption overlooks the possibility that their predicament may be due to certain structural weaknesses such as the concentration of branches in areas where recovery is typically low or other exogenous factors. Of course, losses purely on account of fraud should also not be overlooked.

Narrow banking reduces the net return on assets since risk-free assets are usually low-yielding. This squeezes the already thin spreads available to the weak banks. They would be forced to reduce the interest on deposits. The result would be an automatic reduction in the liabilities. It is, therefore, widely accepted that narrow banking, to be feasible, would require that deposit insurance be confined to these banks so that depositors have an incentive for placing deposits in them. But, if narrow banks are to invest only in risk-free assets and are thus ‘fail-safe’ or run-proof’, then is deposit insurance required at all?

Further, there could be a problem of periodical transfer of deposits from insured institutions to uninsured ones in times of financial stability and vice versa in times of financial distress. As a consequence, both narrow and ‘normal’ banks would have to face asset-liability mismatches, thereby adversely affecting the credit markets.

During times when there is a deposit outflow, the short-term assets may have to be liquidated at a loss. Even though such assets may be risk-free and marketable, they suffer from market risk inasmuch as even government securities are subject to fluctuations in prices. To prevent these fluctuations from affecting the balance sheets adversely, the narrow banks, in view of their special disposition, may have to be exempted from the requirement to mark the securities to market.

If a policy of restricting the credit growth of weak banks is put in place, the better borrowers would be the first to jump the ship since they may not be willing to put up with any freeze on their limits or even the likely delays in sanctioning new/enhanced limits following the condition that incremental resources be deployed only in risk-free assets.

Stopping fresh advances will by itself have an effect of increasing the ratio of non-performing assets (NPA). This, compounded by the loss of some of the better borrowers, will increase the level of NPA. This would lead to poor credit rating/higher risk perceptions. As a result, the narrow bank’s cost of funds would increase pushing it into further difficulties. If restrictions are placed on their ability to raise further deposits, and that too at higher costs, would only increase.

Many of the weak banks already have huge overheads in the form of a wide branch network, including special purpose branches, and personnel specialised in certain areas of lending. Deployment of resources only in government securities would not require the support of this existing infrastructure – both physical and human. Restrictions on lending would increase overheads apart from leaving huge resources idle. Downsizing may prove to be as unacceptable as closure.

Poor quality of the advances portfolio is indeed the main hurdle in the way of weak banks. However, completely shackling their ability to lend may be less preferable to other options. These may include removing certain structural weaknesses as discussed above, improving the legal machinery, including the Debt Recovery Tribunals for faster recovery of loans, setting up of an Asset Reconstruction Fund, giving greater impetus to the growth of securitisation and improving market discipline in various ways.

Risk is inherent in banking. This is more so today than ever before. Similarly, accepting deposits and granting loans are two cognate and inseparable functions. Attempting to separate the two or hoping to assume away risk would be putting the clock back in the evolution of banking. Narrow banking attempts to do precisely this. The concept of narrow banking, though seemingly of great utility, may lead to further weakening of the weak banks. It is, as Neil Wallace of the Federal Reserve Bank of Minneapolis puts it, “a proposal to reduce automobile accidents by limits speeds to zero”.

The author is with Mumbai Zonal Training Centre, RBI; the views expressed here are his own.

© G. Sreekumar 2021.

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