Banking has changed a lot during my lifetime—for the better. The changes are partly due to technology (ATMs, online access), but also to deregulation that subjected banks to a lot more competition. What were the major deregulatory moves and how might they have contributed to the recent crisis? Before addressing those questions, a little personal history.
I got interested in money and banking at a very young age. My mother often took me along on shopping trips, explaining what money was, why we needed it in stores, and how my father got it for us. Trips to the bank were a special treat. The Cleveland Trust branch near us was an imposing affair, with a limestone façade, high ceilings, and tellers ensconced behind ornate barred windows. The architecture was intended to instill confidence, but to me it was just a magic place.
Later, my sixth-grade class operated a student branch of another bank, the Society for Savings. Twice a month our classroom was rearranged like a bank branch. Tellers (all boys, as I recall) would accept student deposits of a dime, a quarter, or sometimes a whole dollar. Assistant tellers (girls) would write the amount of the deposit in the student’s passbook, while the boys handled the cash. After closing we tallied the deposits and packed the loot—perhaps $50—into a canvas bag, and a privileged student would trundle it off to the principal’s office under the watchful eyes of two “guards.” What great lessons we learned: thrift, honesty, attention to detail!
By the time I was 14 I was earning good money shoveling snow, raking leaves, and mowing lawns. I had become something of a saving fanatic. I soon found out that the local savings and loan (S&L) offered higher interest than commercial banks, so I opened an account there. Savings passbooks seem quaint in hindsight, but mine was a treasured possession, a tangible reminder of my growing nest egg.
Not just the passbooks, but the entire banking experience of the 1950s looks quaint from today’s perspective. The banks were open from 10 to 3 five days a week, and there were no automatic teller machines, no debit cards, and only a crude form of credit card (mom’s charge-a-plate was accepted only by the downtown department stores). Those were the days of the 3-6-3 rule of banking: pay 3 percent on deposits, lend it out at 6 percent, and head for the golf course at 3 p.m.
No need to worry about competition. For one thing, potential competing banks from other counties or other states were not allowed to open branches inside Cuyahoga County. And the interest paid on savings accounts was set by government regulators. Banks and especially their S&L brethren did try to compete by offering bonuses like toasters to new account holders.
The stagflation of the 1970s blew the cozy world of banking wide open. When price inflation approached and then exceeded 10 percent, savers began to realize their passbook accounts were guaranteed losers of purchasing power. Some turned to Treasury bills, but at one point the public servants at Treasury, beset by small savers wanting to buy $1,000 T-bills, shooed them away like so many flies by simply raising the minimum purchase to $10,000. Money market mutual funds were devised and helped fill the gap. These funds were a clever innovation that let small savers participate in a pool of short-term, high-quality, market-rate instruments. Prudent management made it possible to maintain a dollar-per-share price, and check-writing privileges were soon added. Eventually this form of asset was included in the broader monetary aggregates. Savings poured out of banks into the new funds.
The banks badly needed relief from the infamous Regulation Q, which capped the interest rates they could pay. Relief appeared in the form of the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA). Interest-rate ceilings were phased out, and for the first time in many years interest could be paid on demand deposits (checking accounts). Repeal of Regulation Q was framed as a consumer protection measure, and rightly so. Interest limits—and price controls in general—are now thoroughly discredited.
The repeal of usury laws decriminalized high-interest personal loans, which was beneficial to marginal borrowers generally. It did, however, contribute in a minor way to the expansion of unsustainable subprime mortgages.
DIDMCA included minor increases in regulation. All banks—not just those that were members of the Fed—became subject to regulation by the Federal Reserve System. The Fed could now set reserve requirements for all banks, offer them discount loans, and provide check-clearing services. Also, deposit insurance, which is a subsidy to the banks, was raised from $40,000 to $100,000 per depositor. It is a subsidy because although banks pay premiums for deposit insurance, those premiums are almost certainly lower than what private insurance companies would charge.
The Garn-St. Germain Act of 1982 soon followed. Banks were allowed to offer money market deposit accounts in competition with the money market mutual funds that had lured so many savers away. There were numerous other minor changes, but the act’s most important provision was deregulation of S&Ls. Savings and loans were bank-like institutions that had been allowed to pay slightly more on deposits but were allowed to offer only one kind of loan: home mortgages. It was this tradeoff, prompted by politicians who saw it as their job to promote homeownership, that primarily distinguished S&Ls from commercial banks. Garn-St. Germain eliminated the S&L interest-rate advantage and raised the limits on the amount of consumer lending and nonresidential real estate lending they were allowed to undertake.
S&Ls held mortgages that yielded modest returns and had many years to run, but by 1980 they were having to pay ever-higher rates to retain deposits, mostly passbook savings accounts payable almost on demand. They were caught in a classic borrow-short/lend-long squeeze. To make matters worse, most S&L managers lacked the specialized knowledge and personal connections necessary for successful commercial real estate lending. These and other factors led to the S&L crisis of the late 1980s. Had they anticipated these developments, Senators Garn and St. Germain might have phased in the changes more gradually. Overall, though, Garn-St. Germain and DIDMCA ultimately strengthened competition and fostered innovation, thereby serving consumers well.
The Financial Institutions Reform, Recovery and Enforcement Act of 1989 was passed as a cleanup measure. Little remains of this act other than the establishment of the Office of Thrift Supervision, currently targeted for abolition.
The Riegle-Neal Interstate Banking and Branching Efficiency Act took effect in 1994. By opening up interstate branch banking, this act finally caught us up with Canada, which has had large nationwide banks almost since the founding of the Dominion. There were no Canadian bank failures at all during the 1930s, when some 9,000 U.S. banks failed. With branch banking outlawed, small towns in the United States could only be served by small and often fragile local banks. This restriction was a major contributor to the two waves of U.S. bank failures during the Depression.
Nowadays we can travel across the country and see familiar bank names like Chase, Citibank, Wells Fargo, or Bank of America. Young people in particular find this no more surprising or disturbing than the ubiquity of McDonald’s or Chevron. Riegle-Neal has been an unqualified success in this regard.
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 takes the stage next. It repealed (for the most part) the separation of investment banking from commercial banking and insurance, as discussed in my and Jeffrey Rogers Hummel’s October Freeman article on the Glass-Steagall Act. Two minor restrictions remain: Investment banks and commercial banks must be held in separate subsidiaries, and commercial banks still cannot hold shares of corporate stock on their books.
Gramm-Leach-Bliley is widely blamed for the banking crisis of 2008–2009. But before the crisis, several of the largest investment banks had remained stand-alone institutions, and it was only after the crisis that they all acquired commercial banks, as allowed by the law. It is not clear that those which had taken advantage of Gramm-Leach-Bliley were any more to blame than those that hadn’t.
The Commodity Futures Modernization Act of 2000 was a classic example of regulatory catch-up. Sophisticated derivative securities called credit default swaps (CDS) had arisen in the markets. A CDS insures the holder of a debt security against default. Risk is thereby transferred from a risk-averse party to a risk-tolerant party at a price agreeable to both. CDS purchasers need not actually hold the reference instrument, in which case they are speculating. Though not entirely new, these derivative securities had exploded in volume as part of a trend toward more sophisticated instruments.
Regulators were at odds as to whether a CDS is a security subject to regulation by the Securities and Exchange Commission or a futures contract subject to regulation by the Commodity Futures Trading Commission. A turf war broke out. Neither side won, and credit default swaps went largely unregulated. But the presumption that regulation would have prevented problems with CDSs is dubious if one thinks, for example, of the failure of the SEC to catch Bernie Madoff even though a whistle-blower tried for years to get it to pay attention.
The Financial Services Regulatory Relief Act of 2006 was concerned with bank reserves. These are the funds banks keep to back up their deposit obligations; they consist of so-called “vault cash” plus their reserve account at the Fed. At present banks must hold reserves amounting to approximately 10 percent of their demand deposit obligations. Although analogous to the stash you and I might keep for personal emergencies, banks cannot draw their reserves down below 10 percent, come hell or high water.
However, elimination of the 10 percent requirement would be a nonevent in today’s environment, given that most banks now choose to hold reserves substantially in excess of 10 percent. At any rate, the requirement can’t be dropped before 2012, and (in case anyone was wondering) there is no way that anticipation of its elimination had anything to do with the financial crisis. Under the act, payment of interest on reserves was originally scheduled to begin in 2011 but was moved up to 2008, as part of the TARP bailout. The original intent of this provision was to provide Fed money managers with an additional tool to shepherd short-term interest rates, but something quite different has happened instead: Payment of interest gave banks a new incentive to hold excess reserves. This incentive is at least partly responsible for an explosion of excess reserves, from about $2 billion to over $1,000 billion in the last two years.
This brief summary of recent regulatory changes has given only a hint of the bewildering array of laws, regulations, and agencies that deal with banking. Commercial banks are regulated by the Federal Reserve System, the Federal Deposit Insurance Corporation, the Comptroller of the Currency, and the Office of Thrift Supervision (OTS). The National Credit Union Administration is a parallel agency for credit unions, and there are also state banking regulators. Competition and rivalry among these agencies may be a good thing if you like the prospect that their squabbling makes them less effective. But the competition got a little crazy, culminating in the great chainsaw incident of 2003.
OTS had gotten oversight of S&Ls. Director James Gilleran marketed his agency as a champion of innovations such as option adjustable-rate mortgages, later to be the downfall of so many unqualified borrowers. “Our goal is to allow thrifts to operate with a wide breadth of freedom from regulatory intrusion,” he said in a 2004 speech.
The Chainsaw Incident
In the summer of 2003 leaders of the four federal agencies that oversaw the banking industry gathered to highlight the Bush administration’s commitment to reducing regulation. They posed for photographers behind a stack of papers wrapped in red tape. One held garden shears and another a bolt cutter, but Gilleran topped them all with a chainsaw! One of Gilleran’s biggest catches was the infamous Countrywide Mortgage, which chose to place itself under OTS regulation in 2007 and proceeded to generate huge volumes of unsustainable mortgages.
Is this an indictment of deregulation? It might better be called “regulatory deregulation,” which is different from genuine deregulation. When banks or any other businesses are highly regulated, their customers stop worrying about their business practices, assuming the regulators have things in hand. If regulators then begin to promote risky behavior while the public continues to believe they are enforcing prudence, problems invariably arise. Such problems would be much less likely if market discipline displaced regulation entirely—that is, scrutiny by stockholders, bondholders, customers, auditors, independent rating agencies, and of course laws punishing fraud and theft.
The record outlined above shows that the deregulatory actions of the last 39 years have been overwhelmingly successful. We must look elsewhere for the causes of the 2008–2009 crisis: government encouragement of risky mortgage lending, low interest rates engineered by the Fed, and to some degree one of the bank regulations that was never lifted. This was the Community Reinvestment Act (CRA) of 1977. This law forced banks to stop “discriminating” against borrowers who lived in low-income areas. In practice this meant diverting some funds away from creditworthy borrowers toward high-risk borrowers. The CRA clearly contributed to the deterioration of credit quality in mortgage lending, but no constituency was strong enough to buck the egalitarian tide and get CRA repealed.
The Dodd-Frank financial “reform” bill is now law. It requires bureaucracies to generate about 67 studies and 243 new regulations, so it’s difficult to say at this point how the new act will play out. Dodd-Frank restricts banks’ “proprietary trading” activities—a concept to be delineated by regulators and, no doubt, artfully skirted by clever bankers. The most important deregulatory reform—allowing nationwide branching—is left intact. Perhaps the act’s full effects will become apparent only when the next financial crisis hits.
[Editor’s note: this essay first appeared in the Freeman on Oct 22 2010]