the plan for the future

Two Types Of Banks

10 December 2019 (latest update: 26 September 2020)

Bank run at the New York's American Union Bank in 1931
Bank run at the New York's American Union Bank in 1931

In the past the banking sector has been split up into different types of banks depending on their risk profile. For instance, the Glass-Steagall Act in the United States severed linkages between commercial banking and investing activities that were believed to have contributed to the 1929 market crash and the ensuing depression. Separating banking from investing can help to prevent banks from providing loans that would boost the prices of securities in which they have a stake.1

The separation of commercial and investment banking prevented securities firms and investment banks from taking deposits, and commercial banks from dealing in non-governmental securities for customers, investing in non-investment grade securities for themselves, underwriting or distributing non-governmental securities, or affiliating with companies involved in such activities.2

The rationale for the separation was the conflict of interest that arose when banks invested in securities with their own assets, which were in fact their account-holders' deposits. It was argued that banks have a duty to protect account holders and should not engage in speculative activities.2

The Glass-Steagall Act included the Federal Deposit Insurance Corporation (FDIC) which guaranteed bank deposits up to a specified limit. It also included Regulation Q, which prohibited banks from paying interest on demand deposits and capped interest rates on other deposit products.3 The rationale for capping interest rates is that it can help to limit the risks banks are willing to take on loans.3

Until the 1980s the legislation remained more or less the same. With the rise of neoliberalism regulations became increasingly frowned upon. Hence the The Glass-Steagall Act was increasingly disregarded. It has been largely dismantled in 1999. Regulation Q ceilings for all account types except demand deposits were phased out during the 1980s. In the aftermath of the financial crisis of 2008 a renewed interest the Glass-Steagall Act emerged.

Natural Money comes with a distinction like the Glass-Steagall Act and for similar reasons. The banking sector is to be divided into regular banks that provide loans and investment banks that are like partnerships investing in equity. Islamic banks operate in this way too. The maximum interest rate of zero works like Regulation Q. It aims to limit the risks banks are willing to take on deposits as interest is a reward for risk and banks could offer higher rates on deposits if they take more risk.

In the United States money market funds have been established to find a way around the limits imposed on banks by Regulation Q. These money market funds could offer fixed rates that were higher than banks could offer. They invested in collateralised debt obligations (CDO) like mortgage-backed securities (MBS). It is therefore not surprising that the financial crisis of 2008 started off in the money market funds, and not in traditional banks.

Banking under the regime of Natural Money is similar to the banking regulation that existed in the United States before the 1980s. It is to operate as follows:
  • Regular banks make loans at a maximum interest rate of zero in terms of central bank currency. They might invest in government securities. Deposits have negative yields.
  • Investment banks are not lenders but participate in businesses. They provide equity. They might be renting houses, leasing cars or leasing other items.
  • Regular banks guarantee the return of deposits at the promised interest rate. The central bank stands behind them. The government may offer a deposit guarantee on regular bank deposits.
  • Investment banks can't guarantee returns. They pay dividends based on the profits they make. Depositors are investors who might face losses.
  • Returns on deposits at regular banks are negative in terms of central bank currency. Investment banks may offer higher returns.
  • The regular bank's capital can cushion losses. An investment bank may have capital too but that may not be needed as depositors of investment banks are investors.
  • Regular banks are always liquid because the central bank stands behind them. Investment banks might not be liquid so deposits might be locked until a buyer for the investments is found.
  • For that reason investment banks may have liquid securities at hand to meet withdrawals.

  • Implementing Natural Money could improve financial stability as equity investments are favoured to debt investments. The maximum interest rate on debts makes debt investments less attractive. As interest is also a reward for risk, high risk debt could be phased out. The improved financial stability can make equity investments even more attractive so leverage may reduce even further and financial stability may improve even more.

    Perhaps the biggest banks are too big to fail. Splitting them up can improve financial stability. Focussing on bank size alone however doesn't address other issues related to financial instability like risk profiles and risk not being transferred to investors who are taking it willingly. Regulations, compliance and competition in financial markets favour scale so that there may be a limit to splitting up financial institutions. Banks also face competition from payment providers like Paypal, Apple Pay or Google Pay. Small banks may find it increasingly difficult to survive in a globalised environment.


    1. The Glass-Steagall Act. Will Kenton, reviewer (updated 5 December 2019). Investopedia.
    2. Glass–Steagall legislation - Wikipedia:
    3. Regulation Q. Will Kenton, reviewer (updated 1 November 2019). Investopedia.