Restructuring the Banking System to Improve Safety and Soundness

• This paper provides a specific proposal to limit the financial activities that are covered and thus subsidized by the government safety net in order to protect the financial system and the economy. The U.S. safety net, which consists of central bank loans to solvent but liquidity strained banks and federal deposit insurance, was developed in the early 1900s to protect commercial banks. • The safety net originally was limited to commercial banks because they are critical to an economy’s overall health and growth. Their core activities of making loans funded by short-term deposits provide essential payment, liquidity, and credit intermediation services. But banks also are inherently unstable because depositors will “run” if they believe their bank is in financial trouble. • While the safety net solves the instability problem, it also creates incentives to take excessive risk because it subsidizes banks. With safety net protection, depositors and other protected creditors are willing to lend to banks at lower interest rates, given the amount of risk. This cheaper funding and reduced market discipline creates incentives for banks to make riskier investments and increase leverage. The subsidy and associated incentive to take greater risks have grown substantially over the past 30 years because the activities the safety net supports has expanded beyond the core banking activities considered necessary to protect. • The recommendation in this paper is to limit the safety net – and thus its subsidy – to what the safety net should protect by restricting banking organization activities by business line. Under the proposal, banking organizations would continue to provide the core services of commercial banks – making loans and taking deposits to provide payment and settlement, liquidity, and credit intermediation services. Other allowable services would be securities underwriting, merger and acquisition advice, trust, and wealth and asset management. Banking companies would not be allowed to conduct broker-dealer ...