Our commercial banking system does not currently provide the needed financial lifeblood for our society.
As New York University professor Nouriel Roubini, founder of global economic and financial analysis firm RGE Monitor pointed out on Jan. 22, U.S. banks are essentially bankrupt. If all the FDIC-insured banks were to write down their total loan losses of $1.1 trillion and securities of $700 billion, it would exceed their combined capitalization of $1.3 trillion by $500 billion.
American policy has promoted a top-heavy banking system. The four largest banks — Bank of America Corp., JP Morgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. — control more than 40 percent of all U.S. deposits. Approximately another 8,380 banks share the remaining 60 percent.
Opponents of America’s super-sized banks complain about two different trends. First, the big banks have crowded out the historical regional banks that serviced the community. Secondly, the commercial bank culture has proved ineffective in managing supermarket financial institutions.
What factors led to our present banking sickness?
Did American regulators err fundamentally when they instituted policies to encourage the concentration of assets among a handful of commercial banks and to allow the provision of supermarket financial services rather than focus on lending?
Several major government policy changes accelerated bigness. First, the government approved nationwide banking after many decades of sanctioning only statewide banking. Secondly, in 1999 it overrode the Glass-Steagall Act that separated commercial and investment banks. Thirdly, the government eliminated the federal deposit cap that prevented a bank from having more than 10 percent of U.S. deposits.
The Glass-Steagall Act of 1933 empowered only commercial banks to take deposits. Over time, the government guarantee of those deposits rose from $2,500 to $250,000. In return for offering this perk, the act forbade commercial banks from trading corporate securities.
The sponsors of the act felt trading was “risky” and impaired the safety of depositors. Instead, investment banks provided this service.
The act also forbade commercial banks from owning an equity interest in corporations in order to prevent a conflict of interest.
The opponents of Glass-Steagall countered that financial innovation made the law an anachronism. Financial engineering blurred the distinction between securities and deposits.
For example, starting in the 1980s Merrill Lynch provided its customers check-writing privileges on their brokerage balances.
In addition, opponents of Glass-Steagall implied that commercial banks would only trade high-quality securities. Therefore, the banks would not only be more profitable but benefit from diversification.
In hindsight, the elimination of the Glass-Steagall Act could have precipitated the recent demise of the large investment banks.
The significant lag time between the rescinding of the act in 1999 and the investment bank failures in 2008 obscures the “cause and effect.”
The former chairman of the board of Bear Stearns, Alan “Ace” Greenberg, articulated the problem of investment banks not having demand deposit funding: “The (investment) banking model does not work because it is at the mercy of rumors.”
Without the benefits of trillion-dollar demand deposits investment banks had a competitive disadvantage in the areas of underwriting, mergers and acquisitions, and security trading. In essence, the investment banks relied upon overnight billion-dollar borrowings to sustain their business model.
The verdict on whether the nation is best served by supermarket banks rather than financial specialists remained undecided. Citigroup, an early supermarket apostle, split into Citicorp (Good Bank) and Citi Holdings (Bad Bank) because its toxic holdings sidetracked management. Citi Holdings represented 45 percent, some $850 billion. Like the prodigal son, the bank has returned to basics.
Unlike Citigroup, JP Morgan Chase developed a successful universal bank. It provided loans, institutional security services and asset management.
To fix the problem, financial institutions must first reduce leverage and sell toxic assets.
Rescue efforts might entail nationalization or the creation of a so-called “bad bank.” This bank would acquire hundreds of billions of troubled securities and loans in order to free up capital so that banks can begin lending.
Over time, the government needs to address whether the problem is super-sized banks or the supermarket model.
Our current malaise contrasts starkly with the sound balanced banking system that arose from the ashes of the Great Depression. We created good statewide banks that serviced their local communities.
We now might have a handful of financial white elephants.
Originally published in the Sarasota Herald-Tribune
