How to Avoid the Next Taxpayer Bailout of the Financial System: The Narrow Banking Proposal

Abstract

As recovery from the present economic crisis begins, policymakers must address what reforms will be made in the financial system in order to prevent the reoccurrence of a similar crisis in the future. In formulating these reforms, policymakers will also have to address the heightened moral hazard and broadened too big to fail doctrine associated with the bailouts of financial firms. These policies to deal with the impact of the crisis have resulted in large federal government deficits, a monetary base expansion with the potential for future inflation, and the depletion of the Federal Deposit Insurance Corporation’s (FDIC) Deposit Insurance Fund (DIF). What will Congress do in response? In terms of long-term financial reform, what is to be expected from Congress is passage of legislation that increases oversight and regulation by the federal financial regulatory agencies. Will the Federal Reserve System (Fed), or some other new or existing federal agency, be given additional regulatory and supervisory power to manage system risk? Will these reforms invite regulatory avoidance behavior by financial institutions or will financial innovation be stifled? These are the important questions that must be answered by any proposal to reform our financial system.

This chapter also appeared as Networks Financial Institute Policy Brief 2009-PB-05.