Narrow Banking on Stablecoins Gains Traction in US

We are on the brink of a significant revolution in monetary finance, a concept long envisioned by prominent economists. This revolution is centered around the idea of "narrow banking" built on stablecoins, which could fundamentally alter global finance, economic development, and geopolitics. The current financial system is based on fractional-reserve banking, a concept that emerged in the 13th and 14th centuries when Italian money changers realized they could hold only a fraction of the coin needed to back their deposits. This system facilitated payments across great distances but also introduced instability due to its inherent leverage. A downturn in the economy could cause more depositors to withdraw savings at once, leading to a "run" on the bank and potential bankruptcy. This instability affects not only depositors' wealth but also economic activity, as banks both generate credit and facilitate payment.

Over the centuries, governments have attempted to mitigate the risks of banking crises. The first central bank, the Riksbank, was chartered in 1668 to lend to other banks experiencing runs. The Bank of England followed 26 years later. However, these measures did not stop solvency crises. The U.S. introduced deposit insurance in 1933, but banking crises, including the 2008 subprime mortgage crisis, continued to occur. Neither deposit insurance nor bank capital regulations solved fractional reserve banking’s endemic fragility, shifting the costs of crises from depositors to taxpayers.

Around the time of the Roosevelt Administration, economists at the University of Chicago proposed the Chicago Plan, or "narrow banking." This plan aims to separate the critical functions of payments and money creation from credit creation. Under narrow banking, "narrow" banks would accept deposits and facilitate payments, backed one for one with safe instruments like T-bills or central bank reserves. Lending would be done by "broad" or "merchant" banks funded with equity capital or long-term bonds, making them less susceptible to runs. This segmentation would eliminate deposit runs, remove the risk to the payments system, and decouple money creation from credit creation, ensuring that bad lending decisions at merchant banks do not affect the money supply or payments.

Despite its potential benefits, narrow banking has not been adopted due to the painful transition and lack of political support. The transition would require existing banks to either call in their loans or sell off their loan portfolios to buy short-term government paper, precipitating a massive credit crunch. Fractional reserve banking is extremely profitable and generates many jobs, making it politically and economically challenging to change. However, recent developments in decentralized finance (DeFi) and the evolution of the U.S. political economy have created conditions that make a shift to narrow banking more feasible.

Stablecoins, decentralized "digital dollars" pegged to fiat currencies or other stores of value, have seen rapid growth. Unlike central bank digital currencies, stablecoins are privately created digital tokens stored and cleared through blockchain technology. They facilitate trust between unknown parties without a government guarantee and have evolved to include real-world uses such as person-to-person and business transactions in countries with unstable local currencies and global remittances. Stablecoins' increasing acceptance and growth as an alternative payments system coincide with legislative efforts to institutionalize them. The U.S. legislation defines acceptable high-quality, liquid assets (HQLA), mandates one-for-one backing, and requires regular audits, creating the legal basis for entities that take deposits, fully back them with HQLA, and facilitate payments in the economy.

This legislative framework closely resembles the concept of narrow banking. However, there are missing pieces, such as access to the Federal Reserve and the definition of stablecoins as money for tax purposes. The omission of access to the Fed likely reflects prudence to avoid undermining the fractional reserve banking system too quickly and the lobbying efforts of the banking industry. Nevertheless, the inclusion of reserves at the Federal Reserve among the approved HQLA for stablecoin issuers hints at a potential transition to a narrow banking model.

The shift in the U.S. political economy and national interests also supports the development of stablecoins. Bipartisan populist anger at banks and the Fed's recent policy errors have increased support for crypto. The combination of popular base and economic muscle is creating a political economy supportive of narrow banking. Additionally, the U.S. has national interests in developing stablecoins, including preventing countries from being "trapped" in a Chinese payments system and creating a significant buyer of U.S. T-bills. The U.S. financial structure, with its greater use of corporate bond markets and securitized mortgages, is more conducive to a non-disruptive transition to stablecoin-based narrow banking, giving it an advantage over rivals.

The economic, geopolitical, and financial implications of a shift to stablecoin-based narrow banking in the United States are vast. It would create significant winners and losers both within the U.S. and around the world. The transition to narrow banking, facilitated by stablecoins, could effectively create a long-held dream of economists: a separation of critical financial functions that enhances stability and efficiency in the global financial system.