Bank specialness has eroded . . . If you went down the bank-asset balance sheet today,
youwould probably say that . . . only about $1.5 -- $2 trillion is special anymore (in the sense
thatdeposit insurance protection is justified for the underlying activities). Why is the safety net
stillso big (protecting nearly $5 trillion of assets in insured depositories), and shouldn't we
thinkabout shrinking it? Robert E. Litan 1
Despite strong earnings, improving asset quality, healthy growth and low failure rates in
thebanking 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.
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
In response to the shrinkage of traditional intermediation, the two-window proposal also permits
banking organizations to conduct nonbank activities of their choice within a structure that is
designed to insulate insured institutions from nonbank risks. This provision likewise occupies a
middle ground, between the status quo that features 'consolidated supervision' of the
bank holding company and limited entry by holding-company affiliates into nonbank financial
activities, and a system of 'universal banking' in which a wide variety of nonbank activities
might be conducted within the legal banking entity itself, funded with insured deposits. 6
The two-window proposal confronts policymakers with some fundamental issues that often are
neglected in discussions of banking reform. The remainder of this article examines one version
of a two-window system and discusses the fundamental issues that arise in connection with these
Comparisons With the
The concept of two windows derives from the same philosophy that underlies the so-called
'core-bank' or 'narrow-bank' proposals for banking reform (these will hereafter be referred to as
'narrow-bank' proposals). 8 A common purpose is to reduce
the risk exposure of the deposit insurance funds (hence, the taxpayer) to the minimum level that
is consistent with adequate safety-net protection for deposits. The common approach is to
restrict the permissible uses of insured deposits and to remove what are argued to be unnecessary
restrictions on the activities of banking organizations. The major differences between the
two-window system and various versions of the narrow-bank proposal relate to the proper means
of achieving a largely common set of goals. The two-window approach departs from most
narrow-bank proposals in the criteria used for determining acceptable uses of insured deposits,
the restrictions imposed on nonbank-affiliate activities, and the structural design of the banking
organization as a whole. These three major differences will be considered briefly in turn.
Activities Funded With Insured Deposits. Narrow-bank proposals tend to use risk
measures alone for determining what are acceptable uses of insured funds 9. Only the safest activities are permitted in the insured entity,
and thus the proposed 'bank' typically resembles a money-market mutual fund: its deposits are
transactions accounts that are serviced through investments in Treasury securies and high-grade
commercial paper. In the two-window approach, the decision whether an activity should be
funded with insured deposits involves more than risk measurement. Also important is whether
there exists a legitimate economic rationale for extending the safety net to the activity in
For example, the traditional banking business of liquidity transformation arguably fulfills a
unique and important economic purpose (the arguments are considered under Risk to the
Deposit Insurance Funds, below). Accepting this premise for the moment, and recognizing
that such intermediation is intrinsically susceptible to destabilizing bank runs that may impose
significant social costs, there is a legitimate economic rationale for extending deposit insurance
to this function. 10 It is much more difficult to provide a
defensible rationale for extending the safety net to products or services that are traded in
established markets with no inherent susceptibility to costly market failures (for example,
foreign-exchange or government securities markets). 11
According to this logic, insured banks should be limited to activities that are consistent with the
traditional business of banking: issuing deposits and other relatively liquid claims, clearing
payments, and investing in short- and intermediate-term illiquid loans such as commercial loans
and, perhaps, some consumer loans, as well as some high-quality investments for liquidity. 12 In the two-window system, all other activities would be
conducted in separately capitalized subsidiaries or affiliates that are not funded with insured
deposits. If there are important synergies between traditional banking functions and certain
nontraditional activities, exceptions would be permitted.
Of course, there would be no avoiding some arbitrary judgments and operational difficulties in
implementing this type of two-window system. How illiquid must a loan be to qualify for
funding with insured deposits, and how should this be measured? Precisely how much
investment for liquidity purposes should be permitted? There are no easy answers to these and a
host of similarly practical questions. 13 In recognizing
that the two-window system would inject some additional arbitrariness and complexity into
banking regulation, however, it should be recognized that some would be removed as well. For
example, there would be no artificial percentage limits on holding-company investments, and
such investments would not be restricted to those activities 'closely related to banking.' Other
examples will be discussed in what follows but, in the final analysis, the two-window alternative
poses a trade-off of the existing set of arbitrary decisions for a different set. >BR>
Moreover, there are alternative versions of the two-window system that would pose fewer
practical difficulties. There is nothing inherent in the basic concept of 'two windows' that
requires a strict adherence to a liquidity-transformation test for determining insurable activities;
thus, at least three different 'two-window' approaches to reform can be identified:
Passive Approach or Status Quo. It might be determined to continue to permit all
activities that currently are conducted by insured banks. New activities could be placed outside
the insured bank and funded through an uninsured window if they are not closely related to the
credit-granting process. The safety net still would shrink if traditional intermediation continues
to shrink, and it could not grow arbitrarily.
Intermediate Approach. Deposit-taking, lending and the holding of some
marketable securities would be permitted for the insured bank, without making judgments about
the degree of liquidity transformation that is accomplished. All other activities would be
conducted in separately capitalized affiliates and funded through an uninsured window.
Activist Approach Based Upon Liquidity Transformation. This option,
emphasized throughout this article, requires a willingness to make judgments about the proper
types of loans and deposits for insured banks, i.e., about the degree of liquidity
transformation that would justify deposit insurance protection, and a willingness to relocate
current activities as needed to uninsured affiliates. Clearly, it poses more practical problems
than the other options.
The third option is the primary focus of this paper because, in the author's judgment, it
reflects the strongest economic rationale for safety-net protection of bank activities. However,
operational and other factors also are important and, as will become evident, many advantages of
the basic two-window structure are equally obtainable under the other two options.
Restrictions on Nonbank-Affiliate Activities. In most narrow-bank proposals, affiliates
of the bank are restricted in their lines of business to some set of financial activities. 14 The operating principle embodied in the two-window
approach is that insured banks should be free to affiliate with both financial and nonfinancial
enterprises provided that: The bank is well-capitalized upon completion of any affiliation
transaction; nonbank affiliates are separately capitalized; and supervisors are satisfied that the
resulting entity will not operate in a manner that is abusive to the bank. Supervisors should have
authority to preclude affiliation if there are concerns about the quality or character of
management in either the bank or the prospective affiliate. Moreover, after an affiliation occurs,
there should exist clear supervisory authority to audit both sides of any transaction between the
bank and its affiliate and to require reporting as necessary from both parties to the transaction.
The general rule for bank supervision in a two-window system is that all advances of bank funds
should be governed by an 'arm's-length' requirement. The two-window framework includes
firewalls and regulatory safeguards to ensure legal and financial separation. 16. For the two-window structure to
function safely and properly, financial flows from the bank to its affiliates must be strictly
The Structure of the Banking Organization. So long as firewalls exist, capital flows
are properly restricted, and proper supervisory measures are taken to ensure arm's-length
dealings among insured banks and their nonbank affiliates, any corporate structure is permissible
under two-window banking. Narrow-bank proposals typically impose a specific structure
(usually resembling a holding company) along with a set of regulations and supervisory
measures that apply to the banking organization as a whole.
17 The two-window structure is designed specifically to avoid this type of oversight and
control: Consolidated supervision has the potential to impede cost efficiency and artificially
reduce the value of the banking franchise, thus inhibiting the industry's ability to attract new
capital. In order to enter banking under current law, nonbank firms typically must subject their
entire organizations to federal supervision. As noted, the two-window system would remove this
deterrent, replacing it with functional supervision of separate corporate units and a system of
firewalls (discussed under Supervisory Issues, below).
Risk to the Deposit Insurance Funds Under 'Two Windows'
Again, the two-window system envisioned in this article would restrict the banking entity to
traditional activities, except where important synergies with nontraditional activities have been
demonstrated. The major risks posed to the deposit insurance funds thus would be the traditional
types of banking risks, primarily related to credit quality, as well as the possibility that problems
at the nonbank affiliates may adversely affect the insured entity. The effectiveness of firewalls
will be discussed in a later section. At this point it is sufficient to note that the risk-reducing
effects of a two-window approach are unclear.
However, risk reduction is not the sole aim of the two-window approach. Narrow-bank
structures would achieve greater risk reduction for the insurance funds than would the
two-window structure. The logic underlying the two-window approach suggests that this extra
risk exposure is worthwhile because, as mentioned earlier, the traditional intermediation function
of banks is considered to be essential for efficient credit allocation in the economy. More
specifically, evidence suggests that an important component of the economy's production
depends primarily upon banks for financing. 18 Such
production is undertaken by firms that, for various reasons, tend to incur prohibitively high costs
in attempting to convey information about their investment projects to potential investors. These
firms are likely to find that they cannot successfully borrow by issuing their own securities, even
when the projects to be financed are viable and productive.
Similarly, not all such firms with viable projects may be able to borrow from finance companies
or other substitute lenders. While these lenders offer commercial loans just as banks do, they do
not offer liquid claims to investors. This may limit their fundraising ability, so that it is unclear
whether nonbank lenders could finance all of the viable projects that depend upon such lending
in our economy.
At first glance, this last point appears counterintuitive. Why could not nonbank lenders attract
sufficient funds from savers simply by offering higher rates of return on their claims? Perhaps
they could, but there may be limits to the willingness of savers to sacrifice liquidity for return.
Benston and Kaufman (1988) cite evidence from the money-market mutual fund experience
indicating that those funds originally guaranteeing a return, instead of a share's nominal value,
eventually were forced via competition to switch to nominal-value guarantees. The
conclusion, as described by Phillips (1994), is that the 'public wishes to have a guaranteed
nominal value, even at the expense of return.' If so, it is equally plausible that, at some point,
individuals will opt for liquidity, even at the expense of return. Intermediation thus may be
reduced if lenders are unable to issue liquid claims. 19
More fundamentally, there are no significant historical examples of strong economies in which
illiquid lending has been financed primarily by private institutions issuing illiquid debt. Because
such institutions have the distinct advantage over banks of reduced susceptibility to runs, it
seems reasonable to believe that fundraising limits may explain their relative obscurity across
time and across different economies. While today's information revolution undoubtedly has
expanded the fundraising possibilities for such institutions, the foregoing discussion suggests
that it is unclear whether they alone could finance all of an economy's viable projects requiring
illiquid loans; 20 some liquidity transformation by banks
may be necessary. As a result, the threat of bank runs may impose large social costs because it
impairs this special banking function and precludes the funding of potentially productive
Under this view of credit markets, there is a presumptive market failure to allocate credit
appropriately in the absence of deposit insurance -- or some equivalent protection -- for
traditional bank intermediation. 21 To remove safety-net
protections from the traditional banking function could easily create more social costs than
benefits if this view is correct.
Such a view is controversial, and a thorough treatment is beyond the scope of this article. 22 Most narrow-bank proponents do not share the
presumption that the market failure cited above is sufficiently important to justify deposit
insurance protection for traditional banking functions. Absent this presumption, it is highly
unlikely that the two-window structure could be viewed as optimal, since narrow banks would
expose the taxpayer to far less risk.
Regardless of which view is correct, this two-window approach serves as a reminder that there is
likely to be no 'free lunch' with deposit insurance reform. Too often when changes in deposit
insurance coverage are proposed, there appears to be an implicit assumption that the risk
exposure of the insurance funds can be reduced costlessly. The two-window proposal reminds
policymakers that real economic costs are likely to be associated with reforms that reduce the
potential for bank intermediation. The relevant issue, of course, is whether these costs are likely
to be smaller or larger than the benefits of the proposed reforms. Given the difficulty of
estimating the benefit/cost ratio with any accuracy, opinions on this issue reflect a high degree of
Profitability and Diversification of Risks
Expanded powers per se may change the risk exposure of the deposit insurance funds:
They will create the opportunity for greater profits as well as greater losses within banking
organizations. Expanded powers could reduce risks for banking organizations if appropriate
diversification rules are followed, but no reliable prediction is possible for the banking industry
as a whole. New investment opportunities will not be exploited identically at different
institutions and similar investment choices may influence risk and return differently at different
institutions, depending upon the characteristics of existing portfolios, the size of new
investments relative to the existing portfolios, and managerial efficiency in capturing any
economies of scope offered by new powers. 23
Although the net effect of new powers via two-window banking is impossible to predict
with any precision, it also may be largely irrelevant. The more relevant fact is that
well-managed banking organizations currently face artificial obstacles to diversifying
appropriately and maximizing returns for their shareholders; these institutions are likely to
become safer and more competitive with expanded powers, potentially benefiting consumers as
well as shareholders and taxpayers. 24 Poorly managed
institutions, on the other hand, likely will suffer the consequences of a new set of poor choices if
expanded powers become available, and many of these firms may fail.
The deposit insurance funds may benefit under a two-window system to the extent that nonbank
risks would be removed from the insured entity and to the extent that scope economies,
synergies or innovations resulting from new powers would salvage some banking franchises that
now are endangered. Capital also would be free to move to nonbank uses within the
organization when banking returns are low, thus stabilizing earnings. More-stable earnings may
allow organizations to provide better support for their banking units during difficult times,
should the owners wish to do so. 25 Meanwhile, any new
risks posed by expanded powers would be borne outside the safety net, if the firewalls and
regulatory safeguards embedded in the two-window structure are effective. 26 If effective, this structure dispenses with any need for
concern about the effects of new powers. Effectiveness is considered in the following section.
Supervisory Issues Under Two Windows
The supervisory issues that arise under the two-window structure may be grouped into two
categories. The first category consists of familiar concerns that apply to any proposed expansion
of banking powers. Foremost among these concerns are the possibility of anticompetitive
effects, including undue concentrations of power, and the potential problems associated with
conflicts of interest, including abusive 'tie-in' sales and improper uses of inside information.
Such concerns have been debated extensively and, thus, are relegated here to an
Appendix that provides a brief summary. The second category of issues deals with the
effectiveness of firewalls in maintaining the safety and soundness of insured banks. Because the
two-window proposal relies so heavily upon firewalls to protect the insured bank without
impairing the ability of the larger organization to capture economies of scope and other
synergies, this category is particularly important for evaluating the relative merits of
two-window banking. The remainder of this section focuses on firewalls.
Firewalls for Safety and Soundness. For purposes of deciding the merits of a
two-window structure, determining whether insured financial institutions can be effectively
insulated from risks posed by their nonbank affiliates is more critical than selecting a particular
set of permissible activities for those nonbanks. If corporate separation can be achieved within a
banking organization and safety-net protections can be confined to the insured bank as required
under the two-window framework, then the selection of activities to be conducted by nonbank
affiliates is of second-order importance.
Economic theory and formal empirical evidence are ambiguous regarding the prospects for
effective separation. 27 Similarly, the abundant anecdotal
evidence on both sides of the question offers no firm conclusions. 28 The following discussion contrasts opposing perspectives
on the feasibility of corporate separation under a two-window system.
Affiliations may carry two types of risks for an insured bank and, ultimately, the insurance
funds: (1) the bank may endanger its own financial health by directly or indirectly assisting a
troubled affiliate, and (2) public confidence may be shaken by problems plaguing a nonbank
affiliate, with negative repercussions for the bank (such as higher funding costs, bank runs,
etc.). For convenience, these risks may be termed 'financial' and 'market' risks,
As noted earlier, financial separation implies separate funding, no commingling of assets, and an
arm's-length requirement for all advances of bank funds to affiliates. It follows that loans or
services obtained by an affiliate from an insured bank should be on terms comparable to those
available for nonaffiliates. Financial separation also requires that a bank does not unduly
transfer assets to, or purchase bad assets from, an ailing affiliate. 'Firewalls' refer to the
behavioral rules and restrictions that promote the fulfillment of these requirements for financial
separation among affiliates.
Banks currently are subject to lending limits, statutory restrictions on transfers of funds, dividend
restrictions, and restrictions on amounts and terms for insider loans. 30 Nonetheless, abuse of an insured financial institution by
individual owners to benefit outside activities has resulted in a number of bank failures. While
this may occur under the strongest of firewall systems, it is relevant to note that state laws
governing corporate separation are uneven. The two-window system would potentially close
state law loopholes that facilitate such abuse by requiring a minimal set of uniform firewalls for
all insured institutions affiliated in any manner with nonbank firms. Despite this, it is reasonable
to expect that the incidence of such abuse will rise if there are expanded opportunities for
There is no doubt that strong incentives exist to manage the various components of an
organization as an integrated whole. For example, funding costs can be lowered for any given
affiliate if creditors believe that the strength of the entire organization stands behind the
affiliate's obligations. To the extent that stockholders' returns can be elevated or risks can be
better controlled by managing the various affiliates as an integrated entity, there will be strong
incentives for management to do so. However, experience confirms that regulators also can
create strong incentives that affect the bottom line for shareholders. The firewalls separating
holding-company affiliates (Sections 23A and 23B of the Bank Holding Company Act) have
insulated many banks effectively against repercussions from the demise of nonbank affiliates,
and such firewalls always can be strengthened if necessary with stiffer penalties for
A fair assessment of the anecdotal evidence would suggest that existing firewalls work well in
the usual course of business but occasionally fail when there are serious problems in one or more
parts of the organization. As Flannery (1986, p. 223) has noted: 'The policy question is
therefore whether the possibility of . . . relatively extreme behavior should have an important
weight in making regulatory decisions.'
A complicating factor is that the anecdotal evidence comes from a regulatory regime that differs
from the one envisioned under a two-window system. Firewalls have, to date, operated within
the context of consolidated supervision for bank holding companies by the Federal Reserve
Board (see note 6). Because the two-window framework does away with consolidated
supervision, it is unclear whether firewalls would be equally effective in that environment.
A counterpoint is that consolidated supervision has served as a signal to the market that
regulators expect affiliates to be managed as integrated entities. This could account for those
past instances in which insured banks have been punished by the market for problems arising in
their nonbank affiliates. Thus, it is unclear whether the market reaction would be similar in an
environment where regulators demand corporate separation and show a willingness to strengthen
firewalls as necessary to enforce it.
As this discussion indicates, complete financial separation is impossible without 'market'
separation. Economic theory and empirical evidence suggest that some amount of market risk is
probably unavoidable for banking units within financial holding companies, even if firewalls
work well. 31 For example, to the extent that customers
seek a complete set of financial products and services from an organization, a nonbank affiliate's
performance in delivering one element of the set will also affect the demand for the bank's
products and services. 32 Similarly, because empirical
evidence indicates that the market uses new information regarding one firm's performance to
infer changes in the stock values of unrelated firms in the same industry, it is reasonable to
expect that the performance of affiliates in businesses closely related to banking will influence
also the market's valuation of a bank. 33
Even if affiliates conduct activities that are unrelated to banking, the market is unlikely to ignore
signs of poor management anywhere in the organization. If the parent selects management of
questionable quality for a nonbank affiliate, the quality of bank management may also come
under suspicion. This will be expressed through higher funding costs for the bank, with or
without the presence of effective firewalls. Moreover, entities within any conglomerates are
likely to be chosen such that their risk-return characteristics are complementary. 34 While firewalls may prevent direct interrelationships
among affiliates, they cannot prevent the indirect connections established through the judicious
use of financial theory and statistical evidence in exploiting covariance or other properties of
asset returns. The market is likely to recognize these indirect connections and understand their
implications for the bank's performance. Correspondingly, a bank's portfolio choices are likely
to be influenced by the risk-return characteristics of its affiliates, even in the presence of
In short, it seems clear that some exposure to market risk will be unavoidable for banks under a
two-window system. Such exposure already exists for holding-company banks, but the
two-window framework places no restrictions on the types of affiliates that banks may choose.
As a result, the mix of affiliates within a two-window organization could have diverse and
complex consequences for a bank's exposure to market risk. More generally, the net effect on
the banking industry's safety and soundness is impossible to predict with confidence.
Given this ambiguity, some argue that a reliance upon firewalls to protect the insured bank
would be too risky. 35 They note that perfect insulation is
not possible, and that attempts to strengthen firewalls may merely negate any economic
advantages resulting from expanded powers. It is not certain that firewalls can be
simultaneously strong enough to maintain an acceptable level of risk for the deposit insurance
funds and flexible enough to allow banking firms to exploit new opportunities or economies of
scope associated with expanded powers. It is argued that these uncertainties signal a continuing
need for consolidated supervision of banking firms in order to catch any problems that may slip
through cracks in the firewalls. Quite apart from the substantive merits of consolidated
supervision, such skeptics note that this concept is firmly embraced in the revised Basle
Concordat; hence, an important international agreement could be threatened by any reforms that
suggest a weakened U.S. commitment to consolidated supervision. 36
The case for two-window banking does not rest upon a denial of these complications and
uncertainties. It rests upon a belief that there are crucial flaws in the structural design of the
banking industry, including the financial safety net, with potential consequences that justify the
risks associated with two-window reforms. More concretely, it appears that the safety net is now
and, in the absence of reforms, increasingly will be extended to activities for which it is not
essential. This creates artificial incentives in the marketplace and raises questions concerning
the future ability of the deposit insurance system to support the safety net. The list of
nontraditional activities conducted by insured banks (foreign-exchange operations, bond
underwriting, off-balance-sheet activities) continues to grow virtually without regard to the
design and purpose of federal deposit insurance. No legitimate economic rationale exists for
extending safety-net protections in this manner. This argument, and the corollary concern over
undue risk to the insurance funds, motivate the redesign of the safety net to protect only
traditional intermediation in the two-window system.
An additional 'two-window' argument for structural reform is that restrictions on bank
ownership and affiliations currently restrain competition in the financial marketplace.
Consolidated supervision appears as an integral part of this problem. It potentially deters entry
into banking by nonbank firms and narrowly restricts activities that may be conducted in
nonbank units of a holding company; thus, it reduces the flexibility of banking organizations to
adapt to a rapidly changing environment and otherwise meet the diverse needs of borrowers and
The two-window proposal, like the recent versions of the narrow-bank proposal, was motivated
by the experience of the 1980s. Enactment of the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA) has changed the landscape significantly.
The FDIC's loss exposure has been reduced by the least-cost failure-resolution requirement of
FDICIA and, perhaps, by the incentives created through prompt corrective action for
undercapitalized institutions (PCA). As well, the Budget Act of 1993 amended FDICIA by
providing that domestic-office depositors of federally insured U.S. financial institutions would
occupy a preferred position in the failure-resolution process with respect to foreign-office
depositors and general creditors. Taken together, these provisions may reduce significantly the
maximum potential failure-resolution costs of the FDIC.
Moreover, FDICIA may have greatly reduced the potential magnitude of the deposit insurance
subsidy by addressing the 'too-big-to-fail' problem. This aspect of FDICIA has been little
noticed and apparently underappreciated. The least-cost resolution requirement generally
prohibits the FDIC from extending protection to any failed-bank creditors other than insured
depositors, unless such action reduces FDIC costs. An explicit process is created for
systemic-risk exceptions, requiring agreement among the FDIC, Federal Reserve, and the
Secretary of the Treasury in consultation with the President, and FDICIA provides for a special
assessment on the industry to pay for any losses exceeding the least-cost amount. Thus, it can be
argued that the process for determining whether large banks get special treatment is similar to,
but more systematic than, the process that might be used for other large firms. 37 It would now be difficult to argue that the deposit insurance
system per se is responsible for any perception in the marketplace that some banks are
'too big to fail.'
On balance, then, FDICIA appears to weaken substantially the case for those reforms aimed
primarily at reducing risk to the deposit insurance fund and eliminating the 'too-big-to-fail'
Despite this, and despite the strong performance of the banking industry recently, it can be
argued that structural reform is necessary because of an overextension of the safety net and
unnecessary restrictions on bank ownership and affiliations. On these bases, the two-window
proposal merits serious consideration.
In particular, a two-window system avoids potential problems posed by reforms that rely upon
'narrow banks' and/or consolidated supervision of banking organizations. Narrow-bank
proposals ignore social costs that may be associated with removing safety-net protections for
traditional bank intermediation and do not address concerns that consolidated supervision deters
entry into banking and restricts the flexibility of banking organizations to meet the needs of
There are legitimate concerns regarding the effectiveness of firewalls in a two-window system.
Given expanded opportunities for bank affiliation with nonbanks, it is reasonable to expect new
temptations that could lead to abuse of insured banks. The effectiveness of firewalls in
preventing such abuse has not been tested in an environment of functional supervision. On the
other hand, to the extent that FDICIA successfully limits the costs associated with bank failures,
reliance on firewalls may pose less risk to the deposit insurance funds and the taxpayers.
Moreover, it should be considered that such a risk may be worth taking in order to rationalize the
financial safety net, bring it under control, and reduce barriers to entry in the financial-services
Competition, Concentration of Power, and
Conflicts of Interest With Expanded Powers
Decreased Competition and Conflicts of Interest. A longstanding fear associated with
expanded product powers and nationwide branching is that a comparatively small number of
large organizations may ultimately dominate the financial marketplace. This raises the specter
of localized monopolies, destabilization of the financial system in the event of a single bank
failure, and disproportionate control over the nation's financial resources on the part of a few
Such concerns are real but difficult to assess. While banking organizations may be larger and
fewer under a two-window system, they also may be better diversified. Thus, while any given
bank failure under this system may be more costly and destabilizing, there may be fewer failures.
Similarly, a decline in the number of banks need not mean that fewer banks will be competing in
any given market. Technological advances in information processing and communications are
constantly reducing the costs associated with entry into new markets. This suggests that if
inadequate competition creates excess profits in a given market, new entrants are likely to be
attracted until above-normal profits are competed away. To the extent that expanded powers
would increase either actual or potential competition, this would provide a safeguard against the
costly excesses typically associated with concentrations of power. 38
For these reasons, it appears unlikely that concentrations of power would produce any serious
economic problems. Under a two-window system, however, other legitimate concerns may arise
in connection with this issue, including potential effects of financial concentration on the
political process. Before committing to any structure that allows for large-scale consolidation in
financial services, lawmakers may wish to consider whether remedies would be available to
offset any untoward implications of concentration. 39
Another longstanding fear associated with expanded powers is that conflicts of interest will
multiply unmanageably as product lines grow, leading to widespread abuses. The primary
concern for bank supervisors is that insured institutions may be jeopardized by attempts to
combat financial problems elsewhere in the organization. For example, banks may be called
upon to make unsound loans, capital injections or asset purchases for the benefit of a nonbank
affiliate. This concern is addressed with firewalls and other regulatory safeguards in the
two-window system, as discussed in the text. The remainder of this Appendix examines
two conflicts that may harm consumers: 'tie-in' sales and improper uses of inside information.
Tie-ins occur when a business entity attempts to condition the sale of a particular product or
service upon the purchase of another of the entity's products or services. Typically, problems
with tie-ins can be traced to inadequate information or weak competition. For example,
extensions of credit to bank customers may be conditioned upon the customers obtaining
additional services from a bank, its parent company, or one of its affiliates. In such cases,
customers may enter into undesirable tie-in arrangements if uninformed of the consequences of
their actions or if unaware of their alternatives. If no viable alternatives exist, customers may
feel compelled to purchase products or services they do not want. The fear is that expanded
powers will create more opportunities and stronger incentives for tie-in sales, so that problems of
this type will become more widespread.
Implicit in the two-window approach is the view that tie-in problems resulting from inadequate
information are best controlled by requiring full disclosure of costs, alternatives, and other
pertinent facts. Likewise, tie-in arrangements arising from inadequate competition are best
addressed through policies that will strengthen competition in the financial marketplace. Under
the two-window system, there would be no geographic or product-line restrictions to protect
firms that saddle their customers with undesirable tie-in arrangements. The potential
competition created by these new ground rules would act as a deterrent to tie-in abuses.
A related concern is that violations of a bank's fiduciary responsibilities might increase along
with the number of products and services offered by affiliates. As banking organizations obtain
new powers, bankers are likely to gain access to new types of confidential information. Skeptics
argue that such information is likely to be misused, because there is a conflict of interest
whenever one entity acts as both a promoter of services or products and a disinterested financial
Such arguments historically have centered on bank involvement in securities underwriting and,
in part, served as the basis for passage of the Glass-Steagall Act. Recent evidence indicates,
however, that, far from harming investors, issues underwritten by bank affiliates prior to 1933
were, on average, of higher quality and better performing than those underwritten by
independent investment banks (Krozner and Rajan, 1994).
More generally, potential conflicts of this type within banking typically have been neutralized
successfully in the past. Because banks generally have succeeded in creating an effective
'Chinese Wall' between their commercial lending and trust departments, for example, it would
seem that similar steps could be taken if banking organizations are permitted to engage in
activities that grant them access to other types of confidential information. Should the level of
abuse prove unacceptable under the two-window system, however, lawmakers could enact
additional safeguards and stiffer penalties. Given the changing dynamics of competition in the
market for financial services, product-line restrictions should probably be viewed as a last resort.
Aharoney, Joseph and Itzhak Swary. Contagion Effects of Bank Failures: Evidence from
Capital Markets. Journal of Business (July 1983): 305-22.
Becketti, Sean and Charles Morris. Are Bank Loans Still Special? Federal Reserve Bank of
Kansas City Economic Review (Third Quarter 1992): 71-84.
__________. Reduced Form Evidence on the Substitutability Between Bank and Nonbank
Loans. In Federal Reserve Bank of Chicago Proceedings: A Conference on Bank Structure and
Competition. Chicago: n.p., 1994.
Benston, George J. The Separation of Commercial and Investment Banking: The Glass-Steagall
Act Revisited and Reconsidered. New York, NY: Oxford University Press, 1990.
__________ and George G. Kaufman. Risk and Solvency Regulation of Depository
Institutions: Past Policies and Current Options. Federal Reserve Bank of Chicago Staff
Bernanke, Ben S. Nonmonetary Effects of the Financial Crisis in the Propagation of the Great
Depression. American Economic Review (1983): 257-76.
__________ and Mark Gertler. Agency Costs, Net Worth and Business Fluctuations.
American Economic Review (June 1989): 14-31.
__________. Banking and Macroeconomic Equilibrium. In New Approaches to Monetary
Economics, William A. Barnet and Kenneth J. Singleton eds. Cambridge, England: Cambridge
University Press, 1987.
Billett, Matthew Thayer, Mark J. Flannery and Jon A. Garfinkel. The Effect of Lender Identity
on a Borrowing Firm's Equity Return. University of Florida Working Paper, June 1993.
Blair, Christine E. Bank Powers and the Separation of Banking from Commerce. FDIC
Banking Review (Spring/Summer 1994): 28-38.
Bryan, Lowell L. Bankrupt: Restoring Health and Profitability to Our Banking System. New
York, NY: Harper Business, 1991.
Carns, Frederick S. Should the $100,000 Deposit Insurance Limit Be Changed? FDIC
Banking Review (Spring/Summer 1989): 11-19.
Carns, Frederick S., Arthur J. Murton and Lynn A. Nejezchleb. No Free Lunch in Deposit
Insurance Reform. In The Financial Safety Net for Consumer Savings: Policy Options for the
1990s. Proceedings of a public-policy forum at Pace University, November 1989, pp. 51-59.
Committee on Banking Regulations and Supervisory Practices. Principles for the Supervision
of Banks' Foreign Establishments (The Revised Basle Concordat), May 1983.
Corrigan, Gerald E. Financial Market Structure: A Longer View. Federal Reserve Bank of
New York Annual Report (February 1987).
__________. Reforming Federal Deposit Insurance, Modernizing the Regulation of Financial
Services, and Maintaining the International Competitiveness of U.S. Financial Institutions,
testimony before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, May 3,
Cornyn, A., G. Hanweck, S. Rhoades and J. Rose. An Analysis of Corporate Separateness in
BHC Regulation from an Economic Perspective. In Federal Reserve Bank of Chicago
Proceedings: A Conference on Bank Structure and Competition. Chicago: n.p., 1986.
Diamond, Douglas W. and Philip H. Dybvig. Banking Theory, Deposit Insurance, and Bank
Regulation. Journal of Business (January 1986): 55-68.
__________. Bank Runs, Deposit Insurance, and Liquidity. Journal of Political Economy
(June 1983): 401-19.
Federal Deposit Insurance Corporation. Current Issues '94. Division of Research and
Statistics. Washington, DC: Federal Deposit Insurance Corporation, 1993.
__________. Deposit Insurance for the Nineties: Meeting the Challenge. (Unpublished Draft.)
Washington, DC: Federal Deposit Insurance Corporation, 1989.
__________. Mandate for Change: Restructuring the Banking Industry. Washington, DC:
Federal Deposit Insurance Corporation, 1987.
__________. Report to the Congress on the Findings and Recommendations Concerning the
Two-Window Deposit System Proposal. Washington, DC: Federal Deposit Insurance
Corporation, September 1992.
Flannery, Mark J. Contagious Bank Runs, Financial Structure and Corporate Separateness
Within a Bank Holding Company. In Federal Reserve Bank of Chicago Proceedings: A
Conference on Bank Structure and Competition. Chicago: n.p., 1986.
French, George. Banking in Transition, a conference on The Financial System in the Decade
Ahead, Jerome Levy Economics Institute of Bard College, April 14, 1994.
French, George and Eric Hirschhorn. Insulation of Banking from Nonbanking: An Empirical
Investigation. In Federal Reserve Bank of Chicago Proceedings: A Conference on Bank
Structure and Competition. Chicago: n.p., 1988.
Goodhart, C.A.E Money, Information, and Uncertainty. Cambridge, MA: MIT Press, 1989,
especially Chapter 8.
Gorton, Gary and George Pennacchi. Nonbanks and the Future of Banking. In Federal Reserve
Bank of Chicago Proceedings: A Conference on Bank Structure and Competition. Chicago:
Kaufman, George G. and Larry R. Mote. Is Banking a Declining Industry? A Historical
Perspective. Federal Reserve Bank of Chicago Economic Perspectives (May/June 1994): 2-21.
Krozner, Randall S. and Raghurm G. Rajan. Is the Glass-Steagall Act Justified? A Study of the
U.S. Experience with Universal Banking Before 1933. American Economic Review
(September 1994): 810-32.
Litan, Robert, E. What Should Banks Do? Washington, DC: Brookings Institution, 1987.
@REFER = Lummer, Scott L., and John J. McConnell. Further Evidence on the Bank Lending
Process and the Capital Market Response to Bank Loan Agreements. Journal of Financial
Economics, 25 (1989): 99-122.
McConnell, C.E. and W.S. Marcias. Bank Loans to REITs: How Serious the Problem? Keefe,
Bruyette, and Woods, Inc., May 1975.
Meyer, Paul. Will Expanded Banking Powers Raise Prices and Reduce Efficiency?
mimeographed, Federal Deposit Insurance Corporation, 1988.
Murton, Arthur J. Bank Intermediation, Bank Runs, and Deposit Insurance. FDIC Banking
Review (Spring/Summer 1989): 1-10.
Phillips, Ronnie J. The New Regulatory Environment and the Functional Approach to Financial
Reform: Establishing Separate Monetary and Financial Service Companies, manuscript, Jerome
Levy Institute, June 1994.
Pierce, James L. The Future of Banking. New Haven, CT: Yale University Press, 1991.
@REFER = Securities Industry Association. Statement before the Subcommittee on General
Oversight and Investigations, Committee on Banking, Finance and Urban Affairs, U.S.
House of Representatives, May 1, 1990.
Seidman, L. William. Proposals to Establish a `Core' or `Narrow' Bank, testimony before the
Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, June 18,
Shockley, Richard and Anjan V. Thakor. Information Content of Commitments to Lend in the
Future: Theory and Evidence on the Gains from Relationship Banking, Indiana University
Working Paper, January 1993.
Swary, Itzhak. Continental Illinois Crisis: An Empirical Analysis of Regulatory Behavior.
(Unpublished Manuscript.) Hebrew University of Jerusalem, January 1985.
Tobin, James. The Case for Preserving Regulatory Distinctions. In Restructuring the Financial
System, Federal Reserve Bank of Kansas City (1987), pp. 167-83.
U.S. Department of the Treasury. Modernizing the Financial System: Recommendations for
Safer, More Competitive Banks, a Report to Congress. Washington, DC: U.S. Department of
the Treasury, February 1991.
U.S. General Accounting Office. Bank Powers: Insulating Banks from the Potential Risks of
Expanded Activities. Washington, DC: U.S. General Accounting Office, April 1987.
White, Eugene N. Before the Glass-Steagall Act: An Analysis of the Investment Banking
Activities of National Banks. In Explorations in Economic History (1986), pp. 33-55.