Gorton and Metrick basically have two proposals here. The first is to regulate money market mutual funds (MMMFs) as "narrow savings banks," and the second is a framework for "narrow funding banks" to intermediate asset-backed securities. As Gorton and Metrick see it, the problem with MMMFs is that they guarantee one dollar return per unit deposited, with the implicit backing of the government, but have an advantage over commercial banks in that, for example, they do not pay deposit insurance premia. To solve this problem, Gorton and Metrick adopt the proposal of the Group of Thirty, which is:
a. Money market mutual funds wishing to continue to offer bank-like services, such as transaction account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value (NAV) at par should be required to reorganize as special purpose banks, with appropriate prudential regulation and supervision, government insurance, and access to central bank lender-of-last-resort facilities.In regulating the shadow banking industry, Gorton and Metrick propose a regulatory framework for "narrow funding banks," which would be the only financial institutions permitted to hold asset-backed securities.
b. Those institutions remaining as money market mutual funds should only offer a conservative investment option with modest upside potential at relatively low risk. The vehicles should be clearly differentiated from federally insured instruments offered by banks, such as money market deposit funds, with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV. Money market mutual funds should not be permitted to use amortized cost pricing, with the implication that they carry a fluctuating NAV rather than one that is pegged at US$1.00 per share.
Narrow Funding Banks would be genuine banks with charters, capital requirements, periodic examinations, and discount-window access. All securitized product must be sold to NFBs; no other entity is allowed to buy ABS. (NFBs could also buy other high-grade assets, e.g., U.S. Treasuries.) NFBs would be new entities located between securitizations and final investors. Instead of buying asset-backed securities, final investors would buy the liabilities of NFBs.Gorton and Metrick's idea is that narrow funding banks will guarantee a safe supply of collateral for repo transactions, which is required for the financial system to work efficiently.
Gorton and Metrick's thinking is encapsulated in their opening two sentences:
After the Great Depression, by some combination of luck and genius, the United States created a bank regulatory system that was followed by a panic-free period of 75 years – considerably longer than any such period since the founding of our republic. When this quiet period finally ended in 2007, the ensuing panic did not begin in the traditional system of banks and depositors, but instead was centered in a new “shadow” banking system.Their view seems to be that, historically, US financial regulation has had many elements of success. Their aim is to take what we have learned from the successes of the past, and apply those lessons to our current predicament. Gorton and Metrick argue that their were three key features of historical banking regulation that provided safe "money." (i) During the free banking era (1837-1863), state-chartered banks issued circulating currency. In this instance, safety was provided by the requirement that these notes be backed by state government bonds. (ii) In the National Banking era (1863-1913), currency was issued by National Banks that were required to back the notes with federal government bonds. (iii) Checks were made safe through the provision of deposit insurance in the 1930s. Gorton and Metrick then argue that the process of intermediating asset-backed securities in the shadow banking system is much like the creation of "money." Shadow banks finance a portfolio of long-maturity asset-backed securities with short-maturity liabilities. Much of these liabilities are overnight repurchase agreements (repo), with the asset-backed securities pledged as collateral. These shadow banks, much like banks during the National Banking era or prior to the establishment of the FDIC, are subject to runs. Thus, as the argument goes, the kinds of government interventions that "worked" to make currency and transactions deposits safe will also work to make shadow banking safe.
Gorton and Metrick's narrow-funding-banking proposal is very much in the spirit of traditional narrow banking ideas, for example as outlined by Milton Friedman in A Program for Monetary Stability. Friedman argued that all private liabilities used in transactions should be backed 100% by the liabilities of the Federal Reserve System. This is of course not exactly what Gorton and Metrick have in mind. What they are proposing is that there be sufficient regulation and supervision of shadow banking that participants in repo transactions can think of the collateral as essentially riskless.
Now, one could view the history of US banking regulation as evidence of "genius" at work, or we could view it as series of attempts to fix a fundamentally flawed system. Indeed, if our only criterion were safety, we do not have to look very far to find a banking system that "works" better. The Canadian system of private note issue was wildly successful relative to either the Free Banking or the National Banking system in the United States. Deposit insurance did not come into force until 1967, yet Canada has never experienced a banking panic episode, and bank failures are very rare events (since 1920: one in 1923, a couple of small ones in the 1980s, none in the Great Depression or during the recent financial crisis). This is basically broad banking at work. Entry into banking is difficult, there is little effort to restrict size (though some mergers have been prevented), and there are no Glass-Steagall restrictions. But banks are tightly regulated; in particular there are stringent capital requirements. Perhaps we could learn as much from this as from US banking history. Maybe the Canadian system is so safe that it stifles innovation, and perhaps we are better off with more innovation and periodic crises. However, it pays to think carefully about this before we implement another fix.
My worry is that we could set up a regulatory structure that permits a "narrow savings bank" for this, a "narrow funding bank" for that, a narrow whatever bank for the other thing, and then wait for the next problem to arise, due to a clever innovator who can find a way to circumvent the new regulatory structure. Maybe a better approach is to embrace big banks, broaden our definition of what we call a bank (part of what Gorton and Metrick have in mind), insure retail transactions deposits at all institutions that choose to offer such deposits, and leave it at that.