Narrow Banking Meets the Diamond-Dybvig Model
Wallace, Neil, Federal Reserve Bank of Minneapolis Quarterly Review
The current version of the 100 percent-reserve banking proposal, called the narrow banking proposal, begins with an observation: The magnitude of safe short-term assets outside the banking system exceeds the magnitude of banks' demand deposit liabilities. Therefore, say the proponents of narrow banking, why not avoid the problems of an illiquid banking system portfolio -- such as the threat of bank runs and the accompanying need for deposit insurance, regulation, and bailout -- by forcing a rearrangement of asset holdings in the economy? Why of require that demand deposits be backed entirely by safe short-term assets? This is the narrow banking proposal.(1) However, this proposal both begins and ends with the same observation. That is, there is no theory or model of banking from which the proposal emerges. In particular, no model is offered which is consistent with the pervasiveness of illiquid banking systems and which also implies that the narrow banking proposal is desirable. This is a serious omission, for two reasons: the supposed problem that the narrow banking proposal is intended to solve would not exist if the banking system were not illiquid, and an explanation in the form of a theory or model of illiquid banking systems is likely to suggest that benefits accompany such systems.
Models do exist, built on Diamond and Dybvig 1983, that are consistent with illiquid banking. These models offer a plausible explanation of the role played by an illiquid banking system; the explanation suggests that some benefits accompany banking system illiquidity. Although the original version of the model seems ill-suited to address the narrow banking proposal because, m that version, the banking system holds all the assets in the economy, simple extensions of the model may be made that are consistent with assets being held outside die banking system. It is presumably such extensions that Diamond and Dybvig have in mind in their critical discussions of the narrow banking proposal. (See Diamond and Dybvig 1986 and Dybvig 1993.) Diamond and Dybvig say d= the proposal makes sense only if die safe short-term assets outside die banking system m the actual economy represent excess liquidity, a fact which they doubt Therefore, Diamond and Dybvig suggest, implementation of the narrow banking proposal would have undesirable consequences.
My purpose here is simply to make Diamond and Dybvig's argument explicit. I set out a version of the Diamond-Dybvig model and point out what the model implies about the narrow banking proposal. My version of the model supports their position: there can be large amount of safe short-term assets outside the banking system, but narrow banking is undesirable. It is undesirable relative to something that bears some resemblance to our current banking system and undesirable relative to something resembling, if anything, a banking system with a large amount of liabilities subordinate, to its deposit liabilities.
Of course, for a variety of reasons, advocates of the narrow banking proposal may be skeptical of this version of the Diamond-Dybvig model and, therefore, skeptical of its implications for their proposal. As with any banking model, this one does not capture some features of actual banking systems. Such skepticism, though, is hardly a persuasive argument for the narrow banking proposal. Any proposal for a major change in policy should be supported by a coherent view of the phenomenon under consideration. In this case, the phenomenon is illiquid banking. Such a view should imply that the policy is desirable, and such a proposal should argue that its view of die phenomenon should be accepted. The advocates of narrow banking have not even begun this process of argumentation. Not only have advocates of narrow banking not made a case, but some of them seem unaware that a plausible model of illiquid banking systems does not lend support to their proposal.(2)
Before examining the model, I will review a few basic concepts. …