Banking and the state

Banks provide not one but two vital services. Bank deposits are the preferred form of safe assets used for transactions, and bank loans allow businesses to undertake risky endeavors. However, this creates a tension in bank business: deposit-holders require safety for bank liabilities to be liquid; while loan-holders want the freedom to take profitable business risks. A widely-used policy to guarantee the liquidity of bank deposits is the government provision of deposit insurance. This thesis considers some of the relative benefits and costs of deposit insurance relative to an alternative of `narrow banking'. This policy argues that a single bank liability structure cannot optimally provide both liquidity and credit. Instead, these two services should be provided by separate entities. These entities could share an owner, provided the safe `narrow' business can be credibly ring-fenced from the risky `wide' bank. Narrow banks issue safe, short-term, debt which can be used for transactions and are invested solely in safe assets so as not to necessitate insurance. To prevent runs, we suggest that wide banks issue longer-term equity contracts to fund risky business credit. Savers are informed of risks up-front and updated through regular markings-to-market. This thesis considers the ability of a narrow banking system to provide liquidity and credit