Efficiency Gains from Narrowing Banks: A Search-Theoretic Approach

In view of the recent proposals on banking reform in the wake of the recent global economic crisis, this paper identifies some efficiency gains associated with narrow banking using an approach based on search theory. It is herein shown that the optimal allocation of resources can be decentralised through competition between narrow banks (which take deposits from households) and finance houses (which make loans to entrepreneurs), whereas such a decentralisation is not feasible for commercial banks (which both take deposits and make loans). When a non-financial agent (such as a household) bargains with a commercial bank, it succeeds in appropriating a share of the value associated with the financial services provided to other non-financial agents (such as entrepreneurs) because commercial banks are affected by search frictions on both the loan and credit markets. This cross-market sharing prevents commercial banks from sharing the value of financial services with non-financial agents efficiently, and can be the origin of credit rationing and multiple equilibria. Because the use of narrow banking suppresses this cross-market sharing, it makes the competitive equilibrium efficient.