Islamic banking and finance

Aqsa Qayyum(1106)

Course Title:
Islamic Banking & Finance

Course Leader & Instructor:

Muhammad Munir Ahmed

Assignment Topic:
Narrow Banking

Submitted By:
AQSA QAYYUM (1106)

CLASS:
MS Banking & Financial Economics (Semester 02)

Department of Economics, GC University

Lahore
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NARROW BANKING
CONCEPT OF NARROW BANKING
A narrow bank is a financial institution that issues demandable liabilities and
invests in assets that have little or no nominal interest rate and credit risk. The
following financial intermediaries are examples of narrow banks:

1. 100% Reserve Bank (RB): Assets are high-powered money in the form of
currency or central bank reserves. Liabilities are noninterest-bearing,
demandable deposits issued in an amount equal to or less than the reserves
2. Treasury Money Market Mutual Fund (TMMMF): Assets are Treasury bills
or short-term investments collateralized by Treasury bills (i.e., repurchase
agreements). Liabilities are demandable equity shares having a proportional
claim on the assets.
3. Prime Money Market Mutual Fund (PMMMF): Assets are Treasury bills
and short-term Federal agency securities, short-term bank certificates of
deposits, bankers acceptances, highly rated commercial paper, and
repurchase agreements backed by low-risk collateral. Liabilities are
demandable equity shares having a proportional claim on the assets.
4. Collateralized Demand Deposit Bank (CDDB): Assets include low-credit-
and interest-rate-risk money market instruments. Liabilities are demandable
deposits that have a secured claim on the money market instruments and are
issued in an amount equal to or less than the money market instruments.
5. Utility Bank (UB): Similar to a CDDB but collateral can include retail loans
to consumers and small businesses in addition to money market instruments.

In the above sequence of examples, asset portfolios are increasingly less

restrictive in terms of their credit- and interest-rate risks. Another difference in
these examples is the composition of liabilities. Some narrow banks issue only
equity shares (TMMMF and PMMMF). Such a liability structure limits the
banks assets to cash and marketable securities for which a net asset value
(NAV) could be readily computed to buy and redeem equity shares. An
alternative liability structure (CDDB and UB) is to issue both demandable
deposits and nonredeemable equity capital.

HISTORY OF NARROW BANKING

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In summary, prior to the early-twentieth century, many US banks functioned

similarly to narrow banks by holding primarily short-maturity assets to match
their short maturity liabilities. Despite the several episodes of banking panics, it
may be argued that panics occurred primarily at banks that deviated from the
narrow-banking ideal.

The financial panic of 1907 led to greater government interventions in banking,

thereby creating fundamental changes in banking operations. One reaction to
the panic was the creation in 1910 of the US Postal Savings System, which
operated as a type of narrow bank (Jessup &Bochnak 1992). The system took
individuals deposits and invested them in Treasury securities or deposits at
local banks that pledged Treasury securities as collateral. The systems design
contained flaws, however, because savings interest rates and rates paid to banks
on deposits were legislatively fixed. A more important response to the 1907
panic was the establishment in 1913 of a government lender of last resort and
central bank in the form of the Federal Reserve System. Access to the Feds
Discount Window made it less costly for banks to hold longer-term and more
illiquid loans.

Waves of bank failures during the early 1930s led to further government
intervention. Most important was the creation of the Federal Deposit Insurance
Corporation (FDIC) by the Banking Act of 1933 (Glass-Steagall Act). FDIC
insurance reduced deposit withdrawal risk due to bank runs, thereby making
leverage less costly.

THE GREAT DEPRESSION IN 1930s

Later, Summers (1975, p.19) states, Term lending was first introduced in the
early 1930s and came as a response to conditions imposed by the Great
DepressionHistorical data provided by 56 (of the) banks revealed that their
outstanding term loans increased three and one-half times from 1935 to 1940
The revolving credit agreement also appeared about the same time as the term
loan. Thus, it is likely that significant term lending would not have been
feasible without FDIC insurance. Summers (1975, p.19) also states that term
lending was encouraged by the Banking Act of 1935, which extended Fed
Discount Window collateral to any sound asset, including term loans. In more

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recent times, loan maturities have continued to rise. Data from the Survey of
Terms of Business lending indicates that the weighted-average maturity for
commercial and industrial loans was 241 days in 1997, rising to 537 days in
2011.

Chicago School Idea of 100% Reserve Banking

An often-cited narrow bank reform was the 1933 proposal by University of
Chicago economists known as the Chicago Plan (Phillips 1996).7 Its main feature
required that banks hold reserves (vault cash plus deposits at the Fed) equal to the
amount of their demand deposits. With demand deposits secured by reserves, they
would be default free, and deposit insurance would be unnecessary. Furthermore,
the M1 money supply (currency in circulation plus demand deposits) would not be
prone to contractions from bank runs as occurred in the 1930s. Other than this
100% reserve requirement for demandable (and checkable) accounts, a bank could
continue the same lending activities that it previously employed but loans and
other assets must be funded with uninsured savings accounts, time deposits, or
equity capital.

Mortgage Crisis of 2008 and reemergence of the idea of

Narrow Banking
The 2008--2009 financial crisis generated new narrow-banking proposals. Mervyn
King, Governor of the Bank of England, supported separating the functions of
banks into those that were utility in nature from those that involved risky
financial activities. Financial functions are considered a utility if their
uninterrupted supply is essential and/or their efficient provision entails a natural
monopoly. Provision of payments settled by a central (bank) clearinghouse would
be considered a utility. Only the utility functions of banks would qualify for
deposit insurance and be regulated.

At the other extreme (Kay 2009), UBs may be quite narrow such that they are
permitted to hold only government securities. However, a middle-ground proposal

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would allow UBs to lend to consumers and small businesses, because retail loans
to these traditionally bank-dependent borrowers could constitute a utility function.

Similarly, in 2011, the U.K. Independent Commission on Banking required large

U.K. banks to ringfence retail and payments-related banking operations in a
separate subsidiary. Activities related to security trading and dealing would be
prohibited and the subsidiarys wholesale funding would be limited.

Pros and cons of Narrow Banking

The benefits of narrow banking seem straightforward and immediately evident.
First, by locking bank assets in high-quality instruments, narrow-banking
regulation would minimize banks' liquidity and credit risks.

Second, as narrow banks would be precluded from supplying loans and

collateralize deposits with high-quality assets, the confidence in the value of their
claims used to make payments could not be weakened by changes in the value of
loans.

Third, with payment system access restricted to narrow banks, payments would be
fully secure since payment system participants would be protected against
liquidity, credit, and settlement risks, and any shock to nonbanks would be
isolated, with no systemic fallout (Burnham 1990, Thomas 2000).

Fourth, narrow banking improves the central bank's ability to control the money
supply process. As a result, capital requirements for narrow banks could be
reduced substantially, the potential recourse to the taxpayer for depositor protection
would become infrequent, and the inequitable too-large-to-fail bailout clause
would be removed by making the failure of large narrow banks less likely. There
would thus be a much lesser need for subjecting narrow banks to special regulation
and supervision (Bruni 1995, Thomas 2000).

Also, since narrow banks would be protected from nonbank activities, a broader
range of activities and a wider ownership structure might be possible for their
nonbank affiliates than under current banking regulations in many countries
(Spong 1993).

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But the downsides to narrow banking do not appear to be any less substantial than
the advantages. Some of them in fact challenge the benefits just discussed. This
section assesses narrow banking against contemporary theories of banking and
shows that narrow-banking regulations would dissipate the benefits associated with
the specialness of conventional banks. This section also evaluates the potential
consequences of narrow banking on finance and the economy, and estimates the
effects of narrow banking on the cost and availability of credit in the economy.

Strong reservations to narrow banking emerge from contrasting its notion with
recent theories of banking. In this subsection, the narrow-banking concept is
evaluated against contemporary theories of banking as a mechanism for: liquidity
generation, optimal contract design, efficient joint-production of deposit-taking and
lending, and money creation.

ISLAMIC VERSION OF NARROW BANKING

An Islamic bank is a deposit-taking banking institution whose scope of activities
includes all currently known banking activities, excluding borrowing and lending
on the basis of interest.
On the liabilities side, it mobilizes fund on the basis of mudarabah or wakalah
(agent) contract. It can also demand deposits which are treated as interest free
loans from the clients to the bank and which are guaranteed.
On the assets side, it advances funds on a profit and- loss sharing or a debt-
creating basis, in accordance with the principles of the Shariah, it plays the role of
an investment manager for owners of time deposits, usually called investment
deposits. In addition, equity holding as well as commodity and asset trading
constitute an integral part of Islamic banking operations. An Islamic bank shares its
net earnings with its depositors.Depositors are required to be informed beforehand
of the formula used for sharing the net earning with the bank.

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NARROW BANKING & ISLAMIC BANKING

Islamic banking provides for payment-settlement as well as credit-provision
arrangements. The former arrangements center around demand deposits while the
latter depends on using Islamic modes of finance to provide credit to the economy.
We can therefore look at Islamic banking from three vantage points. The first
relates to the relationship between demand depositors and banks. The second
relates to the relationship between savers and banks. The final vantage point relates
of the relationship between banks and fund users. The three relationships are
explained below.

A. Demand Depositors and Islamic Banks

Demand deposits in Islamic finance are considered as loans that must be paid on
demand. The monetary system must therefore be structured to eliminate all risk
involved in fulfilling banks obligations towards demand depositors. That is why
some economists called for the application of 100 percent required reserve ratio to
demand deposits (Al-Jarhi, 1983). The proposal for 100 percent required reserve
ratio can also be justified on the basis of efficiency, stability and equity. The
reasons for the first two bases run similar to those used in support of narrow
banking. On the side of efficiency, the banking system requires no deposit
guarantee scheme, is more responsive to market forces and less encumbered with
regulations. The social cost of running the banking system would certainly be less
than in the case with fractional reserves. Banks under the system of 100 percent
reserves are deprived from the ability to issue money (Al-Jarhi, 2002). They would
therefore have less monopoly power. We can therefore conclude that such a system
would be more efficient.
On the side of stability, the banking system would be less likely to face runs on
banks, because of the application of 100 percent reserves. In addition, debt is not
sellable in an Islamic financial system, except at nominal value, while it can be
swapped against assets and other goods and services. The absence of an integrated
debt market reduces the possibilities for the phenomenon of hot money to play a
role at times of crisis (Al-Jarhi 2003).
On the side of equity, we must note that money as a means of exchange owes its
quality to the general acceptance by the public.
Therefore, we can say that the fractional reserve system redistributes wealth to the
advantage of few bankers and at the expense of the whole society. This certainly
runs contrary to equity.

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B. Savers and Islamic Banks

Savers can carry out direct investment, purchase financial instruments or hold
investment deposits. The latter option amounts to entrusting a bank with investing
ones savings. Investment deposits can be unrestricted, i.e., authorizing the bank to
place their proceeds in the general investment pool of the bank, or restricted, i.e.,
authorizing the bank to place them in specific projects, sectors, or funds. According
to the rules of Islamic finance, investment deposits are entrusted with banks on a
profit-loss-sharing basis. The bank sets from the beginning the percentage of profit
that would be allocated to each investment-deposit holder. Investment deposits are
not guaranteed except in cases of negligence or unethical behavior on the part of
the bank. This is similar to the mutual fund or investment bank concept that has
been associated with narrow banking.
The main difference is that the same bank can provide demand deposit services
and accept investment deposits at the same time. Each bank can handle both
transactions and investment services simultaneously.

C. Investment and Islamic Banks

Banks can finance investment through two main categories of modes of finance.
The first is the profit-and-loss sharing modes, which includes forms of equity
(sharing in both capital and management), and forms of fund placement or
mudarabah. The second category includes several forms of commodity finance.
The latter category provides fixed-income placements for banks, as it provides
finance of commodity purchase on the basis of mark-up. A mixture of commodity
and profit-and-loss sharing finance could provide the bank the right combination of
risk and return.

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POLICY DISCUSSION AND CONCLUSION

From the above analysis it seems fair to conclude that narrowing
the scope of banking would, at best, bear less than certain
benefits in terms of greater financial stability, while it would exact
some heavy costs in terms of efficiency and credit availability.
Narrow banking would severe the link between liquidity, money,
credit, and economic activity, which banking has a natural
incentive to establish efficiently (under stable macroeconomic
conditions). By suppressing bank money as an instrument to
finance lending to the private sector, narrow banking would
create serious market incompleteness. The consequent economic
losses might generate incentives for other financial firms to fill in
the gap left by undertaking conventional banking activities.

The economic costs of narrow banking could be particularly

significant for developing countries, where the need is vital for an
efficient banking system both as an engine of economic growth
and a support for the development of a strong nonbank financial
sector. Also, in many developing countries propositions to move to
narrow banking should be resisted given the absence of a well-
developed secondary market for government securities, a highly
volatile environment for securities prices, the existence of
sovereign risk, and a non-credible government commitment not to
insure deposits or financial instruments of large public use.

There is some favor to the idea that narrow banking could be used
in some countries as a response to crises (World Bank 2001). In
particular, weak banks could be required to operate as narrow
banks with a view to fixing their balance sheets. Whereas
selective intervention on individual banks could be justified,
policymakers should be aware that the banks required to operate
as narrow banks would rapidly dissipate their banking knowledge
capital. While mandatory narrow-banking regulations should be rejected,
nothing should stand in the way of individual institutions wanting

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to offer narrow-banking services to their customers on a voluntary

basis, or to create narrow-bank subsidiaries that would be
segregated from other businesses within the same bank holding
companies. While not suppressing the risks inherent in
conventional banking, such solution would retain the money-
creation power of conventional banks, avail risk-averse investors
of a full risk-proof money instrument, and let the financial
institutions and their customers free to opt for conventional
and/or narrow banking instruments based on their own
convenience.

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