The current financial crisis has shown that "too big to fail," or TBTF, financial conglomerates get massive explicit and implicit public subsidies, distorting economic incentives and encouraging excessive risk-taking.

The primary objective of the pending reform legislation should be to eliminate (or at least greatly reduce) TBTF subsidies so that large, complex financial institutions must internalize the risks and costs of their operations.

Paul Volcker's rule would separate banks from proprietary trading and private-equity investments. Sen. Blanche Lincoln's proposal would prevent banks from trading in derivatives. The narrow-bank concept provides the best way to carry out both ideas and to ensure more generally that the biggest financial institutions cannot use federal safety net subsidies to fund their speculative activities in the capital markets.

Congress should adopt a two-tiered system of bank regulation and deposit insurance that includes the narrow-bank concept. The first tier of "traditional" banking organizations would be limited to activities "closely related to banking." First-tier banks would not be allowed to affiliate with companies engaged in securities underwriting or dealing, insurance underwriting or derivatives dealing. They could buy derivatives only for bona fide hedging purposes.

Like today's community banks, first-tier banks would accept deposits, make loans and exercise fiduciary powers. They would continue to operate under their current supervisory arrangements, including their existing deposit insurance.

By contrast, the second tier of "nontraditional" banking organizations (a category that includes large, complex financial institutions) could engage in capital markets activities. However, they would be required to operate their banking subsidiaries as narrow banks.

Narrow banks could accept Federal Deposit Insurance Corp. deposit guarantees but could not accept uninsured deposits. Their assets would be limited to cash and marketable, short-term debt obligations, including government securities and highly rated commercial paper. As a practical matter, narrow banks would operate as FDIC-insured money market mutual funds.

Narrow banks would be prohibited from making any loan or other funds transfer to their affiliates, except for the payment of lawful dividends to their parent holding companies. Narrow banks would also be prohibited from trading in or buying derivatives, except for bona fide hedging purposes. These restrictions would prevent the largest financial institutions from using FDIC-insured deposits or bank-issued bonds to fund their capital markets activities.

It is undisputed that banks obtain funding at cheaper rates than their holding company affiliates because banks receive the most extensive safety net subsidies. The narrow-bank structure would stop large, complex financial institutions from using these subsidies to pump up their profits from speculative activities while imposing the risks of these activities on the FDIC and taxpayers.

The narrow-bank concept must be combined with other reforms designed to control systemic risk and shrink TBTF subsidies. The reforms must include a systemic-risk resolution authority, a systemic-risk supervisor with authority to establish special capital requirements for the largest financial companies and a systemic-risk insurance fund paid for by these complex institutions. Such reforms would reduce the need for TBTF bailouts and also help ensure that the largest companies cannot create excessive risk within their nonbanking subsidiaries.

Both first-tier and second-tier banking organizations should be prohibited from making private-equity investments (or, at least, from making investments that confer control over industrial or commercial companies). Private-equity investments create unacceptable liquidity and market risks for banking companies, and they also threaten to undermine our long-established policy of separating banking from commerce.

The narrow-bank structure and other needed reforms would force financial conglomerates to prove that they can provide excellent customer service and superior investor returns without relying on safety net subsidies and taxpayer-funded bailouts. It is long past time for these conglomerates to show — based on a true market test — that their claimed superiority is reality, not myth.

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