Can Money Market Mutual Funds Private Sufficient Liquidity to Replace Deposit Insurance?

By Miles, William | Journal of Economics and Finance, Fall 2001 | Go to article overview

Can Money Market Mutual Funds Private Sufficient Liquidity to Replace Deposit Insurance?


Miles, William, Journal of Economics and Finance


Abstract

Narrow banking is an arrangement in which deposit-- taking and lending functions are separated and performed by different institutions. This separation is aimed at avoiding panics at uninsured banks, without moral hazard associated with deposit insurance. Money Market Mutual Funds (MMMFs) are promoted as replacements for bank deposits. For MMMFs to compete with banks, they must be able to withstand a monetary shock without losing shareholders in a flight to quality at government-insured institutions. VAR analysis indicates that MMMFs increase share issue subsequent to a monetary tightening. This bolsters the case that liquidity can be provided in a narrow banking framework. (JEL G20, G21)

Introduction

Narrow banking has been proposed as a method of avoiding panics without the inefficiencies of deposit insurance (for an excellent overview see Gorton and Pennacchi 1992, 1993; Kashyap, Rajan and Stein 1999). With depository banks, loans of short and long maturity are financed with demandable deposits. If depositors decide to withdraw en masse, due to information true or false about the intermediary or similar institutions, the bank can collapse, resulting in both financial and economic dislocation (Diamond and Dybvig 1983 for a theory of such panics). The role of bank failures in episodes such as the Great Depression (Bernanke 1983) helped convince policymakers to implement deposit insurance in order to avoid the economic dislocation that often comes with financial crisis.

While it can be argued that deposit insurance has led to greater financial stability since its inception, it is not without cost. The major drawback of deposit insurance is that it can, in the absence of countervailing forces, lead to moral hazard. The savings and loan failures of the 1980s, Japan's decade-long struggles with poor loans, and the role of failed banking systems in many East Asian nations leading up to the 1997 currency attacks are presented by many observers as examples of the dangers of insuring bankers and thus encouraging risky lending at eventual taxpayer expense. In response, proposals to change the banking industry structure have been offered. Narrow banking, one of the most prominent propositions, entails splitting the deposit-- taking and lending functions into two different sets of firms, so that loans are financed with longer-term obligations, rather than with demandable debt (deposits). In so doing, the financial system should in theory be less vulnerable to panics, and would no longer require deposit insurance and its attending distortions. In practice, advocates of narrow banking envision finance and insurance companies taking over the lending function, while money market mutual funds (MMMFs) provide liquidity services.

The focus of this paper will be the feasibility of MMMFs as liquidity providers in a narrow banking system. There has been tremendous growth in MMMF assets over the past several decades (Figure 1). The liquidity that MMMFs offer through checkable, fixed-price shares is similar to that of bank deposits. The feasibility of MMMFs as liquidity providers is of course not a sufficient condition for the success of narrow banking, as there must also be non-bank lenders such as finance companies that can provide credit as banks do without relying on deposits. Nonetheless, the provision of liquidity by one set of non-bank institutions is half of the narrow banking system and a necessary condition for the success of such an arrangement. Whether such liquidity provision is possible is the question addressed by this paper.

As pointed out by Gorton and Pennacchi (1993), a vital issue for the viability of MMMFs as large-scale liquidity providers is whether they are in fact less immune to financial dislocation than banks. If, for instance, an interest-rate shock exacerbates agency problems in credit markets, will holders of MMMF shares exit from the funds and obtain liquid assets from government-insured banks? …

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