Janet Yellen, Chair of the Board of Governors of the Federal Reserve System, gave the opening remarks at the 2014 Financial Markets Conference of the Federal Reserve Bank of Atlanta.
One of the major items that Ms. Yellen discussed was higher capital requirements for commercial banks, especially for the largest banks in the country, higher than even those required by Basel III. The way the momentum is going, it is my belief that commercial banks, especially the largest commercial banks will find themselves facing new capital rules, and, Yellen suggested, even some non-bank financial organizations should face some kind of restriction.
The banking industry is going to be restructured. And, the basic reasoning for the restructuring is the government. The government is attempting to find how it can make the banking system safer and still get from it what the government wants.
When I was learning about the banking system there were three basic rules that seemed to be important in how the banking world was structured.
First, commercial banks needed to have high capital requirements because human nature was such that bankers world always lend as much as they could and take capital ratios to a minimum. That is, commercial bankers needed to be protected from themselves.
Second, a joke from the period goes like this, a lender at a commercial bank should not make a loan unless the borrower did not really need to borrow the money. The idea one should take from this is that, in general, lending standards were quite high during this time.
Third, commercial banks outside of urban areas needed to be protected from the commercial banks in the urban centers. If these urban center banks were allowed to expand into the less-urban areas then they would sweep into the area, take up all the deposits and take the money back to the city where it would lend. Thus, if lending was going to take place in non-urban areas, the larger, city banks needed to be kept out. Thus, we had unit-banking states, limited banking states, and some state-wide banking states.
The American banking system of the 1950s was founded on these basic rules. To understand the reasoning behind these basic rules, a good place to go is a new book by Charles Calomiris and Stephen Haber titled "Fragile By Design: The Political Origins of Banking Crises & Scarce Credit." (Princeton University Press: 2014).
The basic thesis of this book is that the structure of the banking system of a country always has a political origin. Along with the history of other countries the authors examine the history of the United States banking system and show how the politicians of the country created a banking structure that was based upon a populist foundation. And, this system has roots all the way back into the presidency of Andrew Jackson.
This populist foundation emphasized the importance of the "local" nature of commercial banks. Communities needed "local" banks. If the only alternative choice was a bank from a nearby bigger city then the community would suffer because the bank from the urban center would cannibalize the deposits of the local community and siphon the funds off to lend in the larger city. Of course, as Calomiris and Haber go on to show, this was not how other countries saw the needs of the nation. Canada, for example, always only depended upon a few number of relatively large banks located in the bigger cities of the country.
High capital ratios and high lending standards were deemed necessary because with so many banks in the country, some kind of discipline had to be enforced. And, since it was assumed that human nature was such that the bankers would push financial leverage and credit standards to the limit, a culture was created that built "prudence" into the behavior of the bankers. These small banks were generally dominated by one person with the rest of the staff being general employees like tellers, bookkeepers, secretaries, and other office personnel. If the bank got a little larger then there may be another person who could make loans, but the loans were generally overseen by a loan committee…headed up by the president of the bank.
My grandfather was one of these bankers in Missouri, a unit banking state. The smallest bank I ever ran was twenty times larger than the bank he ran in a town, outside the big urban complex of St. Louis, Missouri.
What happened to this system? The politics of banking changed. In the early 1960s the federal government took on a new economic philosophy based upon the goal of achieving and sustaining a level of full employment. Fiscal policy…and monetary policy…was aimed at spurring on the economy and keeping employment at a high level over time. This was the new populism. It is what the people wanted. The era of credit inflation began…and it was a child of both the Republicans and the Democrats.
By the end of the 1960s a new banking environment was in place. Banks, that were asset managers in the past became liability managers because they could now purchase funds in the money markets, not only domestically in the banker's acceptances and commercial paper markets, but also in the newly stimulated Eurodollar market. Banks were no longer constrained size-wise by local markets because they could buy all the funds they wanted at going market interest rates to expand their balance sheets. Local restrictions became less and less relevant.
Banks could also form holding companies, which allowed them to go into other states and form organizations that were not really commercial banks. By the end of the decade the "old" banking structure was disappearing and it just became a matter of time before state banking barriers…among other barriers…began to break down.
Add to these developments the pressure by the federal government to spread home ownership throughout the economy, to use thrift institutions as well as commercial banks as conduits to the creation of residential mortgages assisted by the government's creation of the mortgage-backed security and you get the prelude to the mortgage market becoming the largest component of the capital markets. Then put in there the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) that eventually became the largest holders of residential mortgages in the country and you have a brand new financial system based upon the "new" political origins.
We are just a few steps from breaking down the Glass-Steagall Act and the subprime mortgages. The commercial banks helped to underwrite the federal government deficits that were a part of the economic policy of high employment and carry out the federal government's goal of providing home ownership to more and more Americans…credit standards be damned!
The government got what it wanted at a cost of allowing the banks more and more leeway in what they could do. But, according to Calomiris and Haber, this created the next "fragile" banking system…which resulted in the next "banking crisis".
Now, we are back to the drawing board. The economic policies of the federal government, in place since the early 1960s, have not changed. The government still wants to guarantee high levels of employment and it still wants to provide home ownership to as many people as it can. The dilemma now is how does the government maintain these two economic goals yet with a banking system that is less "fragile" and less the vehicle of "inequality."
The problem, as I see it, is that the government wants to stick with it populist goals. But, it wants to try and reduce the fragility of the banking system. These objectives may not be compatible.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.