If ring-fenced banks were not able to perform their core economic function of intermediating between deposits and loans, the economic costs would be very high. If all current retail deposits were placed in narrow banks, around £1tn of deposits which currently support credit provision in the economy would no longer be able to do so.
Alternative sources of credit could arise – for example if narrow banks could invest only in short-term UK sovereign debt (‘gilts’) the current investors in gilts would need other assets to invest in, since the stock of gilts would be more than taken up by the demand from narrow banks. Thus, those investors might become direct lenders.
Such a system would be less efficient, given that the synergies within banks would be removed, leading to increased costs for customers.
Either way, narrow banking would mean that ring-fenced banks could not be a source of stable credit supply during times of stress. Instead, the supply of credit would move entirely to a less regulated sector.