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Redefining Financial Stability: Narrow Banking Excels in the Digital Age
Francesco Filia, Founder & CEO
9 January 2024
In the ever-evolving landscape of financial services, the concept of ‘’Narrow Banking’’ could re-emerge as a beacon of stability and efficiency, offering a stark departure from traditional banking. While traditional banking operates under a fractional reserve system (in which only a fraction of bank deposits is required to be available for withdrawal), Narrow Banking would require deposit-issuing banks to avoid leverage and steer clear of risky financial investments.
This new banking model would offer compelling avenues for more sustainable methods of lending to the real economy – particularly to small and medium-sized enterprises (SMEs) and consumers. Filling the void left by the retrenchment of traditional bulge bracket banks will be a growing ecosystem of fintech-enabled lenders and private pools of capital.
The rise of narrow banking is not just a theoretical adjustment, but a practical response to the glaring vulnerabilities exposed in traditional banking systems during times of crisis. Last year’s crises experienced by Credit Suisse and Silicon Valley Bank, are but recent reminders that the current system is in desperate need of change, as its fragility is accentuated by the digital revolution in financial services. Narrow Banking could offer a credible solution.
Narrow Banking Defined
At its core, narrow banking is a financial model in which banks restrict their activities to primarily accepting deposits and investing in secure, low risk prime assets. Unlike commercial banks, which engage in a wide range of financial activities including riskier asset investments, complex derivative trading and several turns of leverage, narrow banks, with their emphasis on low leverage (virtually zero) and full equity-backed credit exposure, focus on stability and reduced risk exposure. This model inherently shields them from the sorts of systemic risks that have periodically rattled global financial markets.
The concept of narrow banking complements and facilitates the inclusion of non-bank lenders in the real economy, among which one can count alternative credit asset managers and fintech lending platforms. As we explain below, Fintechs are the real 100% “equity” banking stabilisers.
Systemic Risks in Traditional Banking
The fragility of traditional banks was starkly highlighted by the recent crises involving institutions like Credit Suisse and Silicon Valley Bank (SVB). These cases demonstrated the acute risk of liquidity crises, where a rapid withdrawal of deposits, fuelled by a loss of confidence, can lead to a bank's collapse at an astonishing speed. This risk is magnified in the digital era, where large-scale capital transfers can be executed instantly and information (or just simple rumours) spread globally in a few seconds, amplifying the potential for violent eruptions of bank runs. Short-lived panic can last a short while, and still create outsized and lasting damage. Unlike the gradual bank runs of the past, today’s digital environment facilitates the potential for a swift erosion of a bank's deposit base, underlining the need for more stable models. What has really changed in the past few years is the velocity of cash movements, which can result in the potential for larger damage.
In the past, a period of panic would be followed by bank runs in the form of depositors queuing up at the bank branches distributed across the territory, but the bank closing at night and over the weekend provided time to implement remedial actions and consort a bailout. Most interventions would in fact happen outside of market hours, or during bank holidays, in addition to imposing new ones to gain time. Today, however, vast amounts of deposits can disappear at the click of a finger on a mobile-only cloud-based app, leaving no time for such remedial actions and allowing a moment of panic to spread explosively like a deadly virus. This has vast ramifications for systemic risk at the aggregate level of the financial system. Most metrics utilised today (including liquidity coverage ratios or LCR) are not fit for purpose in properly assessing modern banking liquidity crises and the risk of deposits vaporising overnight: referred to as the ‘daily liquidity risk’ or risk of ‘flash runs’. Banks face a new risk of potential instantaneous calamity, given the use of non-sticky daily deposits to fund long-term loans, on top of the leverage allowed for by current capital regulatory standards. Such standards are much improved from those pre-GFC (with leverage reaching 40x at times seen as with Lehman Brothers and their subsequent collapse), but are still material at approximately 10x, meaning the shock of any potential miscalculation can still have severe consequences.
Flash Runs: The Risk of Exceptionally Fast Bank Runs
The recent case of Credit Suisse, at the time the second largest bank in Switzerland, stands out in exemplifying the fragility of the banking system at times of turmoil, and the deadly effect of the daily liquidity risk and digitally driven bank runs. A brief moment of panic and imbalance can trigger catastrophic consequences. Such is the very definition of highly complex and inherently fragile systems is that they can be tripped by relatively minor shocks. In the case of Credit Suisse, the ripple effect of a bank run on a relatively minor regional bank in California (SVB) sent a freak wave halfway across the globe to capsize the second largest bank in Switzerland. Edward Lorenz’s “butterfly effect” was exemplified in plain sight.
In the case of SVB, depositors withdrew $42 billion in a single day, resulting in the bank collapsing on the spot as regulators could not react quickly enough to put together a rescue plan. Prior to this, the largest ever US bank failure was Washington Mutual in 2008, where $16.7 billion in deposits were withdrawn over a nine day period.
The real question that should be posed is what would have happened if the crisis had spread out from Credit Suisse to UBS, for the sake of argument, or another bulge bracket bank and what would the safety net have looked like. Would the relatively small SNB, the Central Bank of Switzerland, have been able to rescue its banking system?
Taking this argument to its extremes, it could seem possible and materially consequential for several financial institutions to be a few panic moments away from full consolidation into their respective central banks, as a result of flash bank runs.
Consolidation can take place either formally or de facto, as it is the equivalent of raising the threshold for insured deposits to 100%. Eventually, the US Treasury Department analysed ways to expand federal insurance coverage to all deposits on a temporary basis during the SVB turmoil.
Much of the debate today, among regulators, supervisors and commentators, revolves around the split between corporate and retail deposits, as it is asserted that retail depositors will be slower at moving deposits away from frail banks into safer havens, compared with faster moving corporate clients. However, critically, it is easy to imagine how newer generations, the “children of the mums and dads”, may likely be faster to react and take better advantage of the tools provided for by digital finance, mobile only and universally accessibility.
Shifts in Lending Practices
In the United States, a notable shift has occurred with 80% of total loans now being handled outside of traditional commercial banks. This trend points to an increasing reliance on alternative lending platforms and asset managers, a shift not yet fully mirrored in Europe. European banks, mired in their own challenges of fragmentation and inefficiency, continue to provide the majority (over 80% of total lending) of corporate funding through bank loans, the polar opposite to the market structure visible in the US. However, a gradual transition is observable, as European institutions strive to catch up with their American counterparts and prepare for a more digitally oriented future in lending.
The European banking market is as fragmented as it is notoriously resistant to change. The issue is one of geographical breadth of operations. Hardly a bank in Europe is a champion in more than a few countries across the continent. It is a result of the fatigue in the ongoing efforts to create, simultaneously, a fully functional EU single market (a banking union across the EU), a complete EU’s capital markets union. Among the unpleasant consequences of the fragmentation is an SME funding gap in the trillions of euros across the continent. If banks are the only game in town but are dysfunctional and unable to provide access to capital, the system will rebalance itself in ways that make it more efficient, stable and sustainable. Enter: new technologies, fintech platforms and non-bank alternative lenders.
A non-bank alternative lender, like an investment fund, could be more or less dependable on its own equivalent of bank runs, owing to the liquidity terms of the fund itself (closed-ended vs daily liquidity) and on the diversification of its funding base (how many funders and investors, how are they diversified by investor type, etc.). Having said this, it is possible for asset managers to have zero leverage, full diversification across institutional investors (with no one accounting for more than 10% of assets under management, for example), avoidance or low reliance on “hot-money” investors (retail capital or fund-of-funds), preferring instead permanent-type capital sources like pension funds and insurance companies. At that point, one could argue this encompasses a much more suitable lender to the real economy than a highly levered traditional bank relying on a deposit base featuring daily liquidity hot-handed small depositors. This is all the more the case with the digitally-native, short-fused, tech savvy generation Z.
Technological Advancements Reshaping Banking
(ChatGPT-4 generated artwork depicting a highly advanced, futuristic bank setting)
Technology in financial services has many faces, but two are of particular interest here: fintech platforms and blockchain technology. Fintech platforms have emerged in the last decade to reinvent the borrowers’ experience in ways that make it more frictionless, more user friendly, more cost efficient and faster (while still transacting via traditional banking rails). Within this context, ‘’Fintech Lending’’ has emerged as a new force in town, sitting alongside traditional bank lending. To some extent, fintech lending is the emerging property of a system in transition, the alternative path for the system to rebalance itself away from the inefficiencies and rigidities of centralised banking structures unwilling and unable to adjust to the requirements of their clients within the digital age. Fintech lending is the response of the fragile system itself while it seeks a new equilibrium, a stable state.
Further out on the technological spectrum, blockchain and Web3 reinvent the financial rails altogether from the ground up, in what resembles a second derivative of change beyond fintech platforms. Platforms are transformative but consequential and accretive; blockchain and the apps built on top of it are antagonistic, disruptive and cathartic. At current rates, the combination of the two seem inescapable and likely to affect the shape of financial services for decades to come. They represent the veins and arteries of the new financial markets, while artificial intelligence (AI) and computing power are the oxygen running through them.
Technology, particularly blockchain, is playing a transformative role in the financial sector. One of the most interesting use cases is the tokenisation of real-world assets (RWA), streamlining transactions and drastically reducing operational cost. The operational cost comparison between traditional banking giants and blockchain-based platforms, such as the Uniswap Protocol, is staggering, reflecting billions in annual potential savings (from back office to middle office, from custodial services to clearing and settlement/trading, from IT to compliance costs).
This technological revolution is not only about efficiency; it also implies a more volatile banking environment with reduced client retention, as customers can easily switch providers at the first sign of trouble. This adds to systemic risks, greatly fuelling the ‘flash runs’ risk defined above as it increases the “daily liquidity risk” previously outlined. If bank runs cannot lose steam at such times when the bank is closed (overnight or over the weekend), what can stop even the slightest moments of idiosyncratic stress to a single large institution having ripple effects into broader systemic issues?
If the system has two parallel channels, one fragile and the other one resilient, where do we realistically expect the system to balance out, eventually, on a long enough timeline? It is likely for the fragile ecosystem to be competed out over a relatively short timeline.
The Intersection of Fintech, Web3 and AI
The convergence of fintech platforms, blockchain/Web3 and AI is creating a new wide-ranging economic ecosystem. When you look at it as a whole, it represents a way for the financial system to rebalance into a new equilibrium and a plausible future state for market economies. This intersection is consistent with the emerging theory of decentralised systems as inherently more resilient to shocks, a concept deeply embedded in the complexity theory of dynamic adaptive systems. In this context, Fintech represents the evolution of financial services, blockchain the reinvention of financial infrastructure, and AI the catalyst accelerating these transformative tectonic shifts. Add to this a funding model where capital is provided as pure equity (with modest leverage that rarely goes above 1.5x) and the set of characteristics of this new financial ecosystem make it a far superior solution to many of today’s counterparts.
Conclusion
To conclude, in our view Narrow Banking, in a form that includes asset management and Fintechs, is emerging not just as alternative financial practice, but as necessary adaptation to a rapidly changing economic landscape, brought about by the accelerating move into the ‘Digital Future’ of financial services. They offer a sustainable solution to soften the blow from systemic risks while effectively and efficiently serving the real economy. As we embrace a future marked by the interplay of Fintech, blockchain and AI, narrow banking stands as a testament to the potential for stability and efficiency in a world where traditional financial models are no longer fit for purpose. This paradigm shift is not merely a financial evolution; it is a necessary response to the complexities and vulnerabilities of our modern economic systems. It is hard to underestimate the bombshell opportunity in such transformational times, as the players of tomorrow will look very different from the players of today.