Do We Really Need to Break Up the Banks?

Mervyn King, Governor of the Bank of England, gave a speech the other night and set off somewhat of a storm…at least across the pond. And it is a discussion that needs to be heard here in America.

Not only did it get a lot of play in the press, but it elicited an immediate response from Prime Minister Gordon Brown and Alistair Darling, his Chancellor of the Exchequer. Here is an example that appeared in the Financial Times, “King Calls for Break-up of Banks."

Let me point up an excellent commentary, written by Martin Wolf, in Friday morning’s Financial Times." Wolf emphasizes the “artificial” division in financial institutions between “utilities” and “casinos.” He then goes on to discuss how difficult it is—or would be—to distinguish between these two types of organizations so as to set up a regulatory framework that would work.

I would like to add a little more to the discussion so as to second the points that Mr. Wolf makes. Going into the 1960s here in America, the distinction between financial institutions that were considered to be “utilities” which dealt in “debt” and those that dealt in “equities” and, hence, were a lot riskier, was very clear.

In fact, there were many jokes over the next few decades that commercial bankers were “debt” people and could not mix with investment bankers because investment bankers were “equity” people. People laughed at commercial banks going into the venture capital business when they put a “debt” guy in to run an “equity” business. Many suggested that my success in bank turnarounds (I did three of them) was because I was an “equity” guy and understood what it meant to focus on shareholder value whereas bank “guys”—ugh, “debt guys”--didn’t have the foggiest idea.

The first of two common points of understanding about commercial banking early in the 1960s was that commercial banks needed to be a monopoly—or, at least, a part of an oligopoly—within a limited geographic area. (Monopoly is “local” in either a geographic sense or a “product space” sense. For more on this see “Competition Demystified” by Bruce Greenwald and Judd Kahn, (Portfolio: 2005).) The reason for this was that they needed to have market power to exist. (In more technical terms, the banks could not operate in markets where they were price takers.) Monopoly power allowed the banks to earn an interest rate spread between what they earned on the funds they loaned out and what they paid out to depositors.

In many areas of the United States, geographic limitations on banks were very important and a part of the local culture. So we had states that allowed a bank only one office. (My grandfather was a Missouri banker and Missouri only allowed one office per bank. I really didn’t understand this, but it was like a religious truth to the people in the region.) Other states allowed limited branching. (My first banking job was in Michigan—if you don’t include the work I did in my grandfather’s bank—and Michigan allowed limited branching.) Then other states allowed statewide branching—but, you could not branch over state lines.

The second common point was that commercial bankers could not be trusted to operate in a “safe and sound” fashion and therefore had to be closely regulated. That is, commercial bankers always pushed the edge in terms of trying to earn a little more money and would push themselves into riskier and riskier loans. In other words, commercial bankers had to be protected from themselves.

Commercial banks were public utilities: they provided social capital to a society, they were very needed, yet they were potentially very dangerous—not unlike nuclear energy plants.

What changed?

Commercial banks were highly constrained institutions. Their ability to grow was severely limited to the deposit base that could be generated within their “local” area. But, like all human beings, commercial bankers were problem solvers. (Yes, commercial bankers are human beings, although a not very advanced subset of the species.) The bankers found a way to escape the constraints on branching, both within a state and between states. They developed a class of liabilities that they could use to fund their banks that was not limited to the geographic area in which they resided; liabilities that could be purchased or sold in the open market.

This asset class included Negotiable Certificates of Deposit, Eurodollar deposits and Commercial Paper issued by a bank holding company, the funds of which could be distributed to the commercial bank it owned. Liability management at commercial banks came into existence. Now a commercial bank could not only manage its cash position with the use of these instruments, it could expand its balance sheet beyond the scope of “local” branching restrictions. Limits on branching across state lines were doomed.

Now, however, commercial banks became price takers. They could buy or sell all the funds they wanted to at the going market interest rate. Commercial banking changed in the late 1960s and the early 1970s.

Commercial bankers and regulators still gave voice to the idea that the commercial banks were utilities, but this was only lip service. It was no longer true.

Commercial bankers became “traders” and lived more and more off of arbitrage transactions. They still had markets they operated within, in which they were not price takers, but, as the 20th century progressed, the number of these markets declined as a proportion of the whole. You look at bank balance sheets now and the vast majority of assets and liabilities come from markets in which the banks are price takers.

As financial innovation progressed and bank spreads narrowed, commercial banks spent more and more effort trying to generate “fees” on services that did not depend on spreads, increased financial leverage (achieved as a price taker), and greater mis-matching the maturities of assets and liabilities. The second common point mentioned above still applied: bankers always pushed the edge to earn a little more.

The “Age of Financial Innovation” changed everything. Financial innovators discovered that cash flows were just bits of information and information can be divided up in any way you like. Thus, financial instruments could be tailored to meet the specific needs of a particular investor. And you could perform this service for a fee, meaning that you didn’t need to absorb the risk of the transaction and you didn’t need to finance it. Ain’t modern finance wonderful?

Two final points. First, financial innovation is going to continue to take place. The idea that finance is information is spreading to other markets (Information Markets) that deal with physical products, not just cash flows. As computer technology continues to advance and the idea that information can be traded spreads it becomes quite obvious that regulation cannot be put into the boxes or categories we used in the past. It just isn’t going to happen. Second, we are moving into a world in which the idea of regulation may become silly. We used to regulate, somewhat, pornography. With the Internet, control of the availability of pornography is ludicrous. Possible solutions for bank regulation... that is for another post.

Comments

[JAMES CARLINI:]

If you follow capitalism, then you don't need regulation. The market takes care of itself.

Oct 23 06:41 PM

[flow5:]

You hit home. We necessarily have regulated capitalism. In today's world, the "member banks" buy their liqudity, instead of storing their liquidity. And the perversion is that from a system's standpoint, these "member banks" pay for what they already own, i.e., interest on their liabilities (which they created thru the process of fractional reserve banking).

The drive by the commercial bankers to expand their savings accounts has a totally irrational motivation, since it has meant, from a system's standpoint, competing for the opportunity to pay higher & higher interest rates, on deposits that already exist in the commercial banking system.

This shift from demand to time deposits, has converted spendable balances, into stagnant money. This transfer added nothing to the Gross National Product, and nothing will be added so long as the funds are held in the form of time deposits.

Shifts from transaction deposits, to time deposits, simply increases the aggregate costs to the banking system, and adds nothing to the system’s income.

But it does profit a particular bank, Citibank for example, to pioneer the introduction of a new financial instrument such as the negotiable CD (until their competitors catch up); and then all are losers.

The question is not whether net earnings on CD assets are greater than the cost of the CDs to the bank; the question is the effect on the total profitability of the banking system. This is not a zero sum game. One bank’s gain, is less than the losses sustained by other banks.

We have already discovered, too late, that money creation cannot be exposed to the forces of a free market. The money supply is not self regulatory. If private profit institutions are to be allowed the "sovereign right" to create money, they must be severely regulated in the management of both their assets and their liabilities.

The operations of commercial banks and all other involved institutions, cannot be fostered by deregulation. The operations of these institutions must be severely circumscribed and subject to rigorous and informed supervision.

Oct 24 11:48 AM

[MHGSanDiego:]

I agree that "The operations of these institutions must be severely circumscribed and subject to rigorous and informed supervision."

Some of the fundamental requirements for an efficient capital market are;
- many buyers and sellers
- acting with the same information
- good market information helps develop an informed investment strategy.
- investors get to keep their profit or are exposed to their own loss.

Our current banking system rewards failure by extracting resources from smaller, strong institutions towards large, poorly managed, weak institutions. (e.g. FDIC premiums skyrocketing for all banks, for the benefit of large, zombie banks. A similar disparity occurs with bank reserve requirements)

Investors cannot get good information about the condition or soundness of the institution where they might choose to invest. The system of providing a safe place for deposits that can be invested prudently has disintegrated. There do not seem to be any consequences to bad investment management or poor stewardship of shareholder value or bond holder debt. There are no consequences to institutions that break the few remaining laws that control them since fines (IF they are caught) are far less than the potential profit from malfeasance. And, the fines are paid out of corporate cash, not by the perpetrators.

The mortgage debacle has shown that banks who flipped a bunch of MBS for fees had no skin in the game, so they had no reason to be concerned about the performance of the paper they sold. When the credit default swaps (unregulated and not transparent to the markets that relied on them) failed, good ole Uncle Sam picked up the tab.

It seems the correct strategy was to get all of the fees you could by brokering paper, disregard any prudent investment concerns and lay off all risk to other suckers (pension funds, etc.) who thought that default would be insured with mumbo jumbo derivatives. When that crap shoot failed, you could get the government/taxpayers to eat the loss. The same management could then collect large bonuses after they got the government largesse, thus appearing to cover their losses. Of course debtors (bond holders) and shareholders of those institutions did not fare as well as those trusted to oversee the assets and income of financial institutions, who are still bonused regardless of performance.

The current system of "financial innovations" and regulation seems to work well for the executives and managers of large financial institutions. Not as well for investors who trust(ed) them. It also seems that the financial markets are in such disarray, that true knowledge of large financial institutions' condition might cause a panic. So, no need to let us know about stress test results and so forth. Thus, no accurate market information is available to the market participants.

If we continue doing the same thing, with regard to management, regulation and oversight, we can expect the same results.

Oct 24 07:59 PM

[artkarl:]

We need Glass-Steagall again. -Karl Krachenberg

Oct 25 09:30 PM