Since the 1930s, the nation has relied on Federal Deposit Insurance Corp. member banks to provide a safe and convenient payments system, while also channeling funds from savers to borrowers. As we have recently witnessed, this mixture of deposit and credit functions has created an unstable and risky banking structure supported by an extensive federal safety net.

The recent taxpayer bailouts of the financial system indicate some of the weaknesses in this safety net.

Would separating the deposit and lending functions give us a better financial system?

During the savings and loan debacle in the 1980s, Robert Litan of the Brookings Institution put forward a proposal that he labeled "narrow banking" as a solution to the "moral hazard" problem in banking. Litan proposed to create "monetary service companies" — institutions that would serve strictly a payments function and would hold only safe assets such as cash, government securities and high-grade commercial paper.

The Nobel Prize-winning economists Milton Friedman, James Tobin and Maurice Allais all supported the idea of narrow banking. Tobin proposed creating "deposited currency," which would combine the convenience of a checking account with the safety of currency. Also during the 1980s, L. William Seidman, then head of the FDIC who died May 13, proposed what he termed "two-window banking." A two-window banking company would let savers choose between "insured" and "uninsured" windows at which to deposit their funds.

In a narrow banking system, credit would be supplied by separate lending institutions. These could be mutual funds, finance companies or, if desired, government-owned entities like the Reconstruction Finance Corp. of the 1930s. Financial holding companies could operate in the "two-window" manner suggested by Seidman.

A particular problem could be the availability of funds for small-business and consumer loans. Alex Pollock of the American Enterprise Institute has proposed that the Home Loan Banking Act be revived to create community-oriented lending institutions. These companies would be established as mutuals, with members as shareholders and, therefore, owners of the institution, and would be oriented toward community needs.

Advocates of a return to New Deal-style banking regulation forget, or never knew, of a conceptually more elegant alternative to the New Deal reforms that was put forward by prominent economists at the time. Its supporters included Henry Simons, Lloyd Mints and Frank Knight from the University of Chicago; Irving Fisher of Yale, and Lauchlin Currie, a Harvard-trained economist who was a special assistant to President Roosevelt.

This regulatory alternative was variously known as "100% reserves" or "the Chicago Plan" for banking reform. The National Banking Act backed national bank notes with federal government securities, and the Chicago proposal advocated the extension of this principle to demand deposits. Narrow banking is the modern-day variant of this plan.

Had demand deposit banks been so restricted in the 1930s, it would have made federal deposit insurance redundant and "too big to fail" would be a nonissue today.

The enormous growth of banking system regulation in the years after establishment of federal deposit insurance is evidence that the Chicago economists' fears about government growth were warranted.

Should government policy try to maintain the current role of banks in offering both deposit and lending functions with federal deposit insurance or begin an evolution toward a financial system that separates these functions? A narrow banking system would not only protect depositors and forestall future bailouts but also create a way for bankers to compete in other areas without being hindered by regulatory burdens.

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