When the whole financial world has accepted taking risk as a part of life, talking about narrow banking almost seems like talking about elementary arithmetic. In times of booms, big financiers always like to believe that adding two and two can fetch you 22 if you know how to leverage. Where is the fun if at the end of the day you are not able to make money out of thin air? Narrow banking — also known as full reserve banking — must be for lazy people, who don’t want to chase high yields and remain satisfied with counting the same bucks again and again. But in times of big downfalls, we suddenly find much larger audiences for narrow banking. To understand narrow banking, we need to look at the financial world through the eyes of a narrow banker.

Illustration: Jayachandran / Mint

Johnny: I have heard big bullies of the financial market poking fun at the whole tribe of narrow banking in so many terms. But I don’t really understand what narrow banking means.

Jinny: Today most of our banks work on the basis of what is known as a fractional reserve system. So the chances are that you might not have noticed the tiny presence of narrow banks amid so many big boys. But before talking about narrow banking let’s first understand how the fractional reserve system works. In a fractional reserve system, the banks keep a part of their deposits as reserves and use the rest for lending to different borrowers. The presumption is that at any point in time, only a part of the depositors would turn up to take their money back. So what’s the point in keeping the rest of the money idle? Banks working on a fractional reserve system earn their bread and butter by lending their surplus money to borrowers of all shapes and sizes.

Seems like the perfect recipe for earning good money. But fractional reserve banking has its own problems. First, the borrower may default in repayment, leading to a loss for the bank, and second, the bank may face a long queue of depositors seeking their money back. On any normal day the reserves of the bank are more than enough to take care of redemptions. But on a really bad day the bank may exhaust all its reserves. How does one deal with a situation like this? First, banks working on a fractional reserve system use the provision of deposit insurance to reassure their depositors that a part of their deposit will always remain safe even if the bank actually fails. This really helps in avoiding panic among depositors. Second, banks rely on central banks that play the role of the lender of last resort if the banks actually run out of reserves. But deposit insurance or presence of lender of last resort in itself can’t eliminate all bank failures.

Johnny: What is the solution then?

Jinny: The solution lies in what is known as narrow banking or full reserve banking. In the narrow banking system, banks accept deposits and invest only in highly liquid safe securities most commonly issued by governments. In all other aspects, a narrow bank is just like any other bank. They provide services such as cash deposit and withdrawal, cheque payment and settlement, transfer of funds electronically and all other services that a depositor can use. However, narrow banks do not provide any loans to borrowers like you and me. This is the biggest difference between a narrow bank and a bank working on a fractional reserve system.

Johnny: But what’s the advantage of following such a tight squeeze?

Jinny: There are two main advantages of narrow banking. First, narrow banks do not face any problem in meeting any magnitude of withdrawals from depositors because all their money is invested in highly liquid securities that can be quickly converted into cash with a very low transaction cost. Second, narrow banks do not face any problem of bad debts because all their investments are in government securities. So there can’t be a bank failure unless the government itself fails.

But their biggest disadvantage is that narrow banks earn less income on their investments than what their peers in fractional reserve banking earn and consequently, their depositors have to be satisfied with low interest on deposits. But for a highly liquid and safe investment you should always be ready to pay a price.

Johnny: Yes, one should be ready to pay the price. But tell me, Jinny, where can I find a narrow bank in our locality?

Jinny: Take the example of postal savings schemes, the closest example of narrow banking that we can find in our locality. Although post offices do not strictly fall under the definition of banks, they practically do the same things that any narrow bank does. They mobilize small savings which are ultimately utilized by our government. But in one respect postal savings are better off than a strictly narrow bank. The rates of interest on their deposits are as competitive as any other commercial bank. However, their depositors may have to compromise on liquidity.

Johnny: That’s true, Jinny. You can’t always have the best of all worlds.

What: Narrow banking or full reserve banking is different from the predominant system of fractional reserve banking.

How: Narrow banks invest their deposits only in highly liquid safe assets such as government securities.

Why: Liquid assets can be easily converted into cash and investment in government securities minimizes the risks of bad debts.

Also Read all of Shailaja and Manoj K. Singh earlier columns

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com