Vol. 8 No. 2 - Article I - Published: June 1995 - Full Article
A Two-Window System for Banking Reform
by Frederick S. Carns
Bank specialness has eroded . . . If you went down the bank-asset balance sheet today, you would
probably say that . . . only about $1.5 -- $2 trillion is special anymore (in the sense that deposit insurance
protection is justified for the underlying activities). Why is the safety net still so big (protecting nearly $5
trillion of assets in insured depositories), and shouldn't we think about shrinking it? Robert E. Litan 1
Despite strong earnings, improving asset quality, healthy growth and low failure rates in the banking
industry of late, banking reform remains a popular topic among lawmakers, bankers, scholars and
industry observers. This seems appropriate, given the record number of depository institution failures
during the 1980s, record losses for the deposit insurance funds and the changing nature of banking due
to innovation and increased competition. Traditional bank intermediation, the distinguishing feature of
which is the conversion of liquid deposits into illiquid loans, or 'liquidity transformation,' is shrinking as a
share of total economic activity (Figure 1 illustrates two components of this shrinkage). As banks seek
new ways to remain profitable without repeating the results of the 1980s, it is useful to consider whether
the structural design of the banking industry and the accompanying safety net are appropriate for the new
environment. Such considerations underlie the continuing interest in banking reform, and this interest has
generated a variety of reform proposals.
The common goals driving most reform proposals are to remove unnecessary restrictions on banking
organizations that restrain competition for financial services and to eliminate undue risk to the deposit
insurance funds (the Bank Insurance Fund (BIF), and the Savings Association Insurance Fund (SAIF)).
The proposed reforms vary considerably, due in part to different diagnoses of the structural problems in
the industry, different conceptions of banking's role in the economy, and different priorities regarding the
policy objectives of federal deposit insurance.
This article discusses one version of a 'two-window' approach to banking reform. 2 The general approach
is based upon principles set forth in the FDIC's 1987 study of reform issues, Mandate for Change, and it
proceeds from the premise that the industry faces potential long-run problems due to restrictions on the
product lines and ownership of banking organizations. 3 The proposed solution is 'two-window' banking,
whereby customers could choose between a window offering insured deposits and a window offering
various uninsured investments issued by nonbank affiliates. This approach is intended to allow banking
organizations to engage in a wide array of 'nonbank' activities without benefit of insured-deposit funding,
while strictly circumscribing the deposit insurance safety net to cover only traditional banking activities.
A Two-Window System for Banking Reform
by Frederick S. Carns
Bank specialness has eroded . . . If you went down the bank-asset balance sheet today, you would
probably say that . . . only about $1.5 -- $2 trillion is special anymore (in the sense that deposit insurance
protection is justified for the underlying activities). Why is the safety net still so big (protecting nearly $5
trillion of assets in insured depositories), and shouldn't we think about shrinking it? Robert E. Litan 1
Despite strong earnings, improving asset quality, healthy growth and low failure rates in the banking
industry of late, banking reform remains a popular topic among lawmakers, bankers, scholars and
industry observers. This seems appropriate, given the record number of depository institution failures
during the 1980s, record losses for the deposit insurance funds and the changing nature of banking due
to innovation and increased competition. Traditional bank intermediation, the distinguishing feature of
which is the conversion of liquid deposits into illiquid loans, or 'liquidity transformation,' is shrinking as a
share of total economic activity (Figure 1 illustrates two components of this shrinkage). As banks seek
new ways to remain profitable without repeating the results of the 1980s, it is useful to consider whether
the structural design of the banking industry and the accompanying safety net are appropriate for the new
environment. Such considerations underlie the continuing interest in banking reform, and this interest has
generated a variety of reform proposals.
The common goals driving most reform proposals are to remove unnecessary restrictions on banking
organizations that restrain competition for financial services and to eliminate undue risk to the deposit
insurance funds (the Bank Insurance Fund (BIF), and the Savings Association Insurance Fund (SAIF)).
The proposed reforms vary considerably, due in part to different diagnoses of the structural problems in
the industry, different conceptions of banking's role in the economy, and different priorities regarding the
policy objectives of federal deposit insurance.
This article discusses one version of a 'two-window' approach to banking reform. 2 The general approach
is based upon principles set forth in the FDIC's 1987 study of reform issues, Mandate for Change, and it
proceeds from the premise that the industry faces potential long-run problems due to restrictions on the
product lines and ownership of banking organizations. 3 The proposed solution is 'two-window' banking,
whereby customers could choose between a window offering insured deposits and a window offering
various uninsured investments issued by nonbank affiliates. This approach is intended to allow banking
organizations to engage in a wide array of 'nonbank' activities without benefit of insured-deposit funding,
while strictly circumscribing the deposit insurance safety net to cover only traditional banking activities.
Structural Framework
Basic Elements
There are three primary features of the specific two-window structure discussed in this article: (1) Bank
risk-taking is confined to traditional intermediation by restricting the activities that may be funded with
insured deposits: illiquid loans and high-quality securities held for liquidity purposes are to be the primary
assets of insured entities; (2) activities that are prohibited for insured banks are permitted for uninsured
affiliates (perhaps subsidiaries) within the same banking organization, but the insured bank is insulated
from nonbank risks through separate capitalization and a set of reinforcing 'firewalls' to maintain legal and
financial separation; and (3) all ownership and product-line restrictions now applied to banking
organizations are lifted so that new capital can be attracted from other industries and banking
organizations can compete more directly with nonbank and foreign firms.
The 'two-window' approach occupies a unique middle ground between the major types of banking-reform
proposals. So-called 'narrow-bank' proposals, which are discussed below, typically require that banks
invest insured deposits entirely in liquid financial assets so that risk to the deposit insurance funds is
minimal. This reflects a presumption that traditional bank lending can occur safely and sufficiently outside
of the financial safety net. 4 The two-window proposal does not share this presumption. But unlike the
group of modest reform proposals at the other end of the spectrum, there is a presumption underlying the
two-window approach that banking reform must proceed beyond a mere 'turning of the dials' on existing
policy instruments; for example, adjusting capital standards, accounting standards, or levels of depositor
protection. In response to the shrinking role of traditional bank intermediation in today's economy, the
two-window proposal offers a redesigned safety net that will shrink in a corresponding fashion.
Stated otherwise, the size and shape of the safety net would be adjusted as necessary under the two-
window system to ensure that deposit insurance protects only the 'traditional' type of bank intermediation.
5 Perhaps more important than reducing risk for the deposit insurance funds, this measure is intended to
rationalize the scope of safety-net coverage so that any risk exposure of the deposit insurance funds
serves a legitimate economic purpose.
Basic Elements
There are three primary features of the specific two-window structure discussed in this article: (1) Bank
risk-taking is confined to traditional intermediation by restricting the activities that may be funded with
insured deposits: illiquid loans and high-quality securities held for liquidity purposes are to be the primary
assets of insured entities; (2) activities that are prohibited for insured banks are permitted for uninsured
affiliates (perhaps subsidiaries) within the same banking organization, but the insured bank is insulated
from nonbank risks through separate capitalization and a set of reinforcing 'firewalls' to maintain legal and
financial separation; and (3) all ownership and product-line restrictions now applied to banking
organizations are lifted so that new capital can be attracted from other industries and banking
organizations can compete more directly with nonbank and foreign firms.
The 'two-window' approach occupies a unique middle ground between the major types of banking-reform
proposals. So-called 'narrow-bank' proposals, which are discussed below, typically require that banks
invest insured deposits entirely in liquid financial assets so that risk to the deposit insurance funds is
minimal. This reflects a presumption that traditional bank lending can occur safely and sufficiently outside
of the financial safety net. 4 The two-window proposal does not share this presumption. But unlike the
group of modest reform proposals at the other end of the spectrum, there is a presumption underlying the
two-window approach that banking reform must proceed beyond a mere 'turning of the dials' on existing
policy instruments; for example, adjusting capital standards, accounting standards, or levels of depositor
protection. In response to the shrinking role of traditional bank intermediation in today's economy, the
two-window proposal offers a redesigned safety net that will shrink in a corresponding fashion.
Stated otherwise, the size and shape of the safety net would be adjusted as necessary under the two-
window system to ensure that deposit insurance protects only the 'traditional' type of bank intermediation.
5 Perhaps more important than reducing risk for the deposit insurance funds, this measure is intended to
rationalize the scope of safety-net coverage so that any risk exposure of the deposit insurance funds
serves a legitimate economic purpose.