Why Save the Banks? The Ambivalent Liberal's Guide to Reform

Something in the liberal soul recoils from banking reform. Americans of many political stripes tend to view finance as an arcane or venal realm. But because financial issues seem the special concern of the rich, they offer spartan soul food for advocates of the downtrodden. Often, the politics of high finance seems an insider affair among money-grubbing bankers, brokers, and insurers, with nary a worker in sight. The liberal impulse is to constrain banks rather than to strengthen them to serve the real economy.

The industrial world, by contrast, with its long-suffering masses, arouses more sympathetic interest. Liberals promote American industrial competitiveness largely free of worry that they also might be serving the private purposes of American industrialists. If one doesn't shed tears for General Motors, one can cite concern for auto workers. Yet to display such concern for the global role of a Citicorp or J.P. Morgan & Co. seems to constitute consorting with the enemy.

Such thoughts are suggested by the timid attitude of congressional Democrats in the current debate on bank reform, the most momentous since the New Deal. Where Democrats presided, somewhat reluctantly, over two earlier waves of bank reform -- the first ending with creation of the Federal Reserve under Woodrow Wilson, the second with deposit insurance under Franklin Roosevelt -- they now hug the sidelines, faulting Republican proposals. Beyond wanting to bolster deposit insurance and tighten bank supervision, they offer few blueprints to redesign a creaking system.

In part, the passivity of the Democrats stems from their limited role under a Republican president. Yet, despite his popularity in foreign affairs, George Bush is vulnerable on the banking crisis, which has nearly emptied the federal deposit insurance fund. Widespread bank failures have deepened the recession and will weaken any recovery. Perhaps it is too cynical to say that Democrats do not want to repair the damage too quickly. Henry Gonzalez, chair of the House Banking Committee, does have a definite plan for Unking a replenishing of the Federal Deposit Insurance Corporation (FDIC) with much more stringent bank examination and capital standards. But most Democrats prefer to have Bush take responsibility for new bank reforms that might antagonize competing financial sectors or pose new economic risks.

The savings and loan crisis demonstrated the colossal costs associated with misguided financial reform, seemingly discrediting deregulation. It is now firmly fixed in the minds of many legislators that additional entrepreneurial powers for banks can only invite further trouble and more costly rescues down the road. The natural reaction is to freeze the status quo.

However, Democrats do not seem to know where they stand on these issues, or why. Between 1933 and 1980 so few bank failures occurred that bank reform vanished from the agenda. As recollection of first principles faded, the Democrats' memory lapse was soothed with money from political action committees of the financial industry. Today, liberals seek solace in broad attacks on Reagan deregulation, a critique that masks the absence of an alternate program. But the current crisis demands solutions that go beyond merely curbing bank abuses: we must also restore bank profitability.

Private Purse, Public Purpose
Despite leftover populist misgivings, liberals should support strong, healthy banks. The chronic instability of our financial system is a more glaring competitive weakness, vis-a-vis our trading partners, than our industrial shortcomings. While bank failures are rare as solar eclipses elsewhere, they are as common as rain here. During the past decade, 1,200 American banks failed despite an economic boom. According to the FDIC, another thousand banks, with $400 billion in assets, tremble on the brink. The S&L scandal is a new chapter in an old story. For two centuries, the American banking system has been bedeviled by small, thinly capitalized, poorly managed institutions that expire in record numbers. It is time, finally, to end the curse of bank failures.

As a starting point, liberals might ask: what is the function of banks and what concerns should guide reform? Banks offer consumers a means of payment, a safe place to park money, and a source of loans for homes and other purchases. For business, banks supply daily credit needs and longer-term expansion funds. Banks are both economic accelerators and brakes. If they ration credit too much, they starve the economy; if they are too bountiful, they feed speculation. The Federal Reserve Board's conduct of monetary policy, of course, is supposed to operate in a realm independent of the credit-worthiness of borrowers and the safety and soundness of banks. But when banks are too speculative in their lending, or too tight in response to recent trauma, their actions become a surrogate monetary policy and occasionally a perverse one. In the mid-1980s, bank lending practices accelerated a speculative boom that should have been restrained; today, in a recession, they are overly cautious. Bank reform should return the granting of credit to its proper realm both by restoring the preconditions for bank profitability and by demanding consistent standards for the granting of credit.

At the same time, policy must ensure that the financial system serve small depositors and businesses. Where banks were once rich man's turf, they have become something of an embattled sanctuary of the poor and middle-class, with affluent depositors defecting to brokerage house money-market funds. Almost a third of consumer borrowing today takes place via credit cards, but poor Americans often lack the credit history to qualify. So those households that most need banks are the historic constituency of the Democratic Party.

Likewise small businesses. In our deregulated, global system, big corporations increasingly bypass banks and turn to insurance companies, pension funds, commercial credit firms, investment banks, and foreign banks. Some conservatives react to banks' woes with the flip but apt rejoinder: why save them? Indeed, without remedial legislation, unregulated financial companies will supersede regulated banks for many borrowers. The main casualties will be small enterprises.

Liberals should also be concerned about repairing banks for the sake of preserving communities. Every recent bank crisis bears a state's name. Massive S&L failures wrecked deposit insurance systems in Maryland and Ohio, then created debacles in Colorado and Arizona. When oil prices plummeted, disaster engulfed every top Texas bank. More recently, bank failures have infected Rhode Island, Massachusetts, and New Hampshire. These epidemics destroy towns as businesses lose credit, local realty markets tumble, and regional economies stall. Paradoxically, the historic ban on interstate branching, designed to preserve community autonomy, has left them prey to local bank failures.

Before federal deposit insurance came along in the 1930s, failures might wipe out depositors but left taxpayers untouched. Today, taxpayers can foot the entire bailout bill. This exposure creates a double political imperative. Banks must be profitable enough to accumulate thick capital cushions to ward off trouble. At the same time, regulators must prevent misuse of insured funds, through timely intervention with sick banks and an end to deposit insurance abuse by rich individuals and institutions.

A final objective should be to fortify American bank competitiveness abroad. Since the 1970s, some major banks derive a majority of their profits from abroad. Yet even our largest banks barely struggle into the global list of top banks. In 1990 Citicorp ranked tenth in size worldwide, Chase Manhattan thirty-seventh, Bank America forty-third, and J.P. Morgan & Co. fifty-fifth. When France has seven banks larger than Chase Manhattan or Italy three banks larger than J.P. Morgan & Co., we can perhaps retire the bogeyman of the all-devouring Wall Street banks. Buffeted by foreign rivals, who control 20 percent of domestic banking assets, America's major banks no longer pose a serious threat of excessive power. Their weakness has hindered them from supporting industrial companies as do their counterparts in Germany and Japan, where banks monitor corporate performance, tide companies over during distress, and generally stabilize the industrial sector.


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How does the pending legislation serve these diverse goals? Some of the concerns mentioned above are well served by the reform package presented to Congress by Treasury Secretary Nicholas Brady in March. By creating a new species of financial holding company, the plan would allow banks to branch interstate, underwrite securities, and sell insurance and mutual funds. It would simplify the regulatory structure, scale back deposit insurance, and let commercial companies buy banks. In short, it would permit a rough counterpart of the large "universal" banks of the sort that exist in Western Europe -- banks notably more stable than our own.

For a liberal to endorse a Republican program is admittedly uncomfortable, signaling a retreat from old populist shibboleths that the financial system must be tightly segmented by product and region. But the American banking system no longer supports liberal values. What agenda is served by a new bank failing every other day? The problem cannot simply be blamed on deregulation, for unlike S&Ls, commercial banks were only partly deregulated. They were free to bid for deposits by paying higher interest rates but were not awarded new powers. (To be sure, they were supervised with breathtaking leniency.) In assessing the deepening weakness of U.S. banks, one must look beyond Reaganomics to some enduring historical causes.

Ideological Debits No sector of the American economy so plainly bears the imprint of past mistakes as banking. Banking reform has defied standard ideological categories, almost to the point of a complete role reversal. Many Democrats, for instance, once championed a national banking system, a stand now associated with Republicans. As we shall see, the same debates and the same ideological confusion have recurred for two centuries. Had it not existed, the term deja vu would have been invented by an American banking historian.

The debate over whether banks should be local or national goes back to Hamilton and Jefferson. When he established the first Bank of the United States in 1789, Alexander Hamilton tried to create national standards for banks by refusing to accept the paper of weak banks. His bank's charter, however, was not renewed in 1811. And when Andrew Jackson killed the second Bank of the United States in 1836, the U.S. was left without a central bank for almost eighty years. Far from slaying "the interests," this vacuum permitted the private, baronial Morgan bank to function as an ersatz central bank. Not for the first time, attempts to punish banks backfired and instead harmed the public interest in a coherent banking system.

Jefferson preferred local banks as a bulwark against eastern financiers and concentrated political power. In a capital-short frontier society, indebted farmers favored easy terms to set up banks. With few sources of credit, reformers feared bankers could acquire dictatorial power, and hence kept bank regulation on the state level. In the early nineteenth century, only states could grant bank charters, initiating the regulatory hodgepodge that still plagues us today. Adding to segmentation, many states outlawed branch banking altogether, creating a mosaic of tiny "unit-banks."

During the Civil War, Treasury Secretary Salmon P. Chase introduced America's first paper currency, "greenbacks," then tried to form a national banking system regulated by a new Comptroller of the Currency. This was both an expedient to finance the war and an effort to stem financial chaos. To qualify for national charters, banks had to endure stiff capital and reserve requirements and surprise visits from examiners. These national banks, presumably, would anchor the system with institutions whose federal supervision was a guarantee against failure, and whose paper would be good as gold. However, the new system was only nominally "national" since the new banks could operate in only one state. Nor did these better regulated national banks stamp out state-chartered banks. Many banks opted for more obliging state charters, and by century's end they outnumbered national banks.

Proponents of national banking hoped to promote more effective regulation, for an atomized banking system weakens regulators no less than banks. Without uniform national standards, bankers tended to flee to the least exacting regulatory environment. Multiple regulators, far from toughening supervision, provided scope for scoundrels to maneuver and local politicians to meddle on their behalf. During our own S&L crisis, high-fliers again switched between state and federal charters, exploiting this freedom to dilute standards nationwide.

The 1907 panic on Wall Street demonstrated anew the need for a central bank that could serve as a lender of last resort and provide an elastic currency. Noting J.P. Morgan's private supervisory role in the rescue, Senator Nelson Aldrich commented, "Something has got to be done. We may not always have Pierpont Morgan with us to meet a banking crisis." If many populists viewed central banks as transparent fronts for business, Brandeis Progressives believed that a democratically accountable central bank would tame Wall Street. Many Democrats were at first lukewarm toward a central bank and Woodrow Wilson largely ducked the issue in the 1912 campaign. In the wake of the famous Pujo hearings into the Wall Street Money Trust, the progressive impulse was to punish banks, not strengthen them. In 1913, the new structure was christened the Federal Reserve System to disguise the fact that the U.S. now housed that dreadful beast, a central bank.

The Federal Reserve permitted the government to mobilize scattered bank reserves in emergencies. Until 1929 this stopped the panics that were such a destructive, if colorful, part of the American panorama. But it did not cure the structural weakness of banks. While national banks conformed to stricter Federal Reserve standards, many state banks and trust companies boycotted the new system. The Federal Reserve System faced a dilemma still with us: how to make bank charters attractive enough to entice banks to join the system, without sacrificing standards. Instead of abolishing the comptroller of the currency, the 1913 act added another bureaucratic layer, triggering endless feuds among the Federal Reserve, the Treasury, and the Comptroller.


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While Americans were justly proud of their Federal Reserve System, it didn't check bank failures. Instead, the situation dramatically worsened. By 1921 America's faith in community banks had spawned a staggering 31,000 of them -- several in every congressional district. They effectively blocked attempts to consolidate the system. When A.P. Giannini's Bank America surged across state lines, small banks secured passage of the 1927 McFadden Act, which has thwarted interstate banking ever since. Hence, the United States has far more banks per capita than any country on earth and suffers from a perpetual overcapacity that invites bankers to do foolish things to cover overhead.

The fatal weakness of small banks is that they lack diversified deposit and loan portfolios and are hostage to local products and real estate markets. As the U.S. economy experienced local recessions in farming, oil, coal, and textiles in the 1920s, 5,000 community banks failed. These Main Street bankers, incidentally, often behaved like 1980s S&Ls, colluding with local realtors, bidding for deposits, and looting banks for private gain. And they parted depositors from their money without the bait of deposit insurance.

Hydra-headed Reform
After the 1929 crash produced twin deflations in real estate and securities prices, the wave of bank failures spread from the South and West to the entire nation. The annual number of failures rose from 491 in 1928 to 2,298 by 1931. By FDR's March 1933 inaugural, 34 states had padlocked all or some of their banks; the bank holiday closed the remainder. When banks reopened, their numbers had shrunk to 13,000 -- about today's figure. By contrast, the Canadian system, dominated by ten large national banks, didn't suffer a single Depression failure. As a general rule, the fewer banks in a country, the fewer are the failures.

The current system emerged during the tumult of the early New Deal. In 1933 the Senate Banking Committee held an inquest into Wall Street depredations of the 1920s. Counsel Ferdinand Pecora blamed the securities affiliates of commercial banks for having fed the speculative frenzy. He hauled before the microphones hapless small investors who had bought Latin American bonds from banks. It turned out National City, Chase et al. had taken their bad Latin loans, packaged them as bonds, then fobbed them off on unsuspecting investors.

Investor outrage spurred the Banking Act of 1933, also known as the Glass-Steagall Act. Reform once again was partly punitive in spirit. The bill split the industry into commercial banks (which take deposits and make loans) and investment banks (which issue and distribute securities.) Future critics would note that the scams so dazzlingly exposed by Pecora were twice corrected: through Glass-Steagall and the Securities Act of 1933, which forced underwriters to disclose conflicts of interest. The 1933 bill also introduced national deposit insurance, set at $2,500 per account, adding another regulator, the FDIC, to the existing jumble of agencies.

Past experience had shown the limits of deposit insurance. Seven states had experimented with such systems and they all went broke for the same reason: local banks lacked diversification. If wheat tumbled, Kansas banks folded; if oil plunged, Texas banks skidded. Roosevelt feared deposit insurance could prop up small-town Republican banks and license irresponsible lending. Senator Carter Glass, the bill's author, at first resisted deposit insurance, preferring a national banking system that would end the perennial instability of small banks. Only when the opposition of Huey Long and other populists killed national banking did Glass grudgingly accept deposit insurance to prop up small banks. Far from spearheading bank reform, FDR rather coyly temporized on deposit insurance and other issues.

As in 1913, some Democrats favored national banks. Many who didn't were driven less by philosophy than the fear of offending local banker campaign contributors. Far from reducing banker power, as advocates hoped, a decentralized banking system planted a cohesive pressure group in each community, with its attention riveted on one congressman -- a situation that still makes change fiendishly difficult. The American phobia toward bankers has produced a country positively riddled with them. It has also made the large New York, Chicago, and California banks curiously impotent in urging reform.

After 1933, bank failures abated. In 1936, no bank failed for the first time in nearly six decades, while from 1942 to 1980, a meager 198 banks failed -- about the number that now fail per year. The curse indeed seemed exorcised. Even in 1980 only fifteen banks failed in a grim economic climate.

Why this sudden stability? The solution was partly Malthusian: so many banks failed during the Depression that only the hearty survived. The years of panic also produced a generation of bankers haunted by hard times and cautious to the point of being hidebound. These scarred veterans would reign over American finance in the early postwar years.

In the post-New Deal era, liberals also trumpeted the wonders of deposit insurance. It seemed a magic wand that had calmed the financial waters. In hindsight, we must modify that enthusiasm, for bank failures soared in the 1980s despite an expansion of deposit insurance from $40,000 to a robust $100,000. What, then, produced four and a half decades of un-American calm?

Hot Money
The New Deal also gave regulators the power to limit interest rates paid on deposits. In the 1920s, fierce bidding for deposits had led banks to pay ever higher interest rates, then make riskier loans to cover them -- shades of the S&L scandal. Interest rate caps did steady banking. Unfortunately, they were doomed by 1970s inflation, which drove consumer inflation rates above interest rate ceilings. Money flowed from banks into a brand-new, uninsured industry -- brokerage house money-market funds. Unencumbered by expensive branch networks, often requiring just a telephone and computer, these operations could dispense with regulation, deposit insurance premiums, and the need to hold reserves against deposits at the Federal Reserve. So they could pay higher interest rates and still turn a profit.

It is worth noting that the banking crisis started, not under Reagan, but in the 1970s, as new competition prodded banks into reckless new lending. By no coincidence, that decade yielded a series of disastrous lending fads -- for shipping, real estate investment trusts, and Latin America -- that signaled an end to the prudential ethic of the postwar years.

To allow them to recapture money from the brokerage houses, Congress freed banks from interest rate caps in the early 1980s. But bank failures resumed their upward trajectory. Henceforth, commercial banks bid for deposits, not only against rival banks and thrifts, but against "non-banks" that were outside the framework of banking regulation and depository insurance. As in the 1920s, banks and S&Ls leapfrogged each other to pay high interest rates, supporting them with speculative loans to Latin America, corporate raiders, or property developers. This frenzied competition was fed by the huge tide of cash produced by Federal Reserve Chairman Paul Volcker's conquest of inflation, the Reagan tax cuts, and the buoyant financial markets and boom of the 1980s. Just when the system urgently required a moderating hand, banking regulators opened the throttle wide. By the late 1980s, combined bank and S&L failures were running at 400 to 500 per year, rivaling the gruesome Jazz Age statistics.

The situation was no less parlous on the lending side. At Glass-Steagall's enactment in 1933, commercial banking was still sufficiently profitable that J.P. Morgan & Co. -- Wall Street's foremost universal firm -- opted for banking and spun off the securities house of Morgan Stanley. Commercial banks monopolized a lucrative product, wholesale lending, and booked fat spreads on such loans. This steady income reinforced the residual conservatism of bankers shaped by the Depression.

But in the 1970s and 1980s, corporate borrowers circumvented banks, by issuing their own bonds or commercial paper (LO.U.'s) at lower interest rates. In the new global financial markets, multinational corporations could raise money in many countries and currencies. The power balance shifted from banks to corporate clients as the world became a buyer's market for financial services. Stripped of blue-chip business, banks turned to smaller customers, more hazardous loans.

Today's financial scene cruelly perverts the spirit of Glass-Steagall. Where its authors wished to segregate "safe" lending from "risky" underwriting, they ended up with opposite results. The protective barrier has penned banks into a money-losing business, luring them into risky ventures. Such is the power of stereotypical thinking, however, that people still talk about "safe" lending even as 150 to 200 banks fail yearly.

These lending tribulations have been compounded by the nonbanks. By law, a bank is an institution that takes deposits and makes loans. By engaging in only one or the other activity, nonbanks can bypass regulators. These financial upstarts have poached spectacularly on bankers' turf and now account for a quarter of the $550 billion in commercial loans, almost 60 percent of the $606 billion in consumer loans. Unless banks operate in a more attractive regulatory environment, they will be eclipsed by these footloose firms. Either regulated banks will be given expanded powers to compete or there won't be any banks left to regulate.

But why save regulated banks at all? In part, because poor Americans might not find a place in the system of credit cards and money-market funds that would replace them. In part, because banks are the financial sector most directly connected to the conduct of monetary policy. Further, the demise of the regulated sector would also mean the demise of deposit insurance, for the government would never insure depositaries it couldn't supervise. Regulated banks are a necessary counterweight to the highly competitive nature of the new financial system.

In an age of chronic inflation and interlaced markets, it is impossible to cap interest rates without money migrating elsewhere. Totally unregulated banks, perforce, will bid for deposits and be tempted to cover them with risky lending. These bidding wars can rage unchecked until a speculative crackup occurs. Only regulation, in the form of tighter supervision, higher lending standards, and adequate capital ratios, can allow healthy banks to flourish in the new competitive environment.

However, regulation should not be understood as unwarranted restriction. The paradox that offends the populist soul is this: banks need to be profitable if they are to be responsible. So banking reform requires a delicate blend of some regulatory tightening and some loosening. Let us look at some specific issues being debated on Capitol Hill to see where the booby traps lie.

Interstate Branching
This may be the least problematic reform. Blessed with a vast, diversified economy, the United States should have strong, resilient banks, with troubles in one place offset by prosperity elsewhere. Regional markets seldom move in synchronized fashion and could provide compensating advantages for national banks. By the time New England real estate collapsed in the late 1980s, Texas was reviving. A bank operating in both states would have muddled through. Instead, we have a system in which local downturns destroy one isolated state system after another.

Approval of interstate branching will merely accelerate existing trends. In the 1980s, regional pacts formed "super-regional" banks operating in several states. In some respects, this was a poor halfway house. Many banks undertook rash, debt-laden expansion and obtained an illusory diversification. Bank of New England faltered because the states where it operated -- Massachusetts, Connecticut, and Maine -- shared the same real estate disaster. Yet super-regionals present a bridge to the future and provide buffers against big New York banks blanketing the country.

Technological advances have already made separate state bank systems somewhat fictitious. Large banks market credit cards nationally. The ubiquitous automated teller machines, which first sprouted locally, now form national networks. Increasingly, banks are mere transit points for deposits and loans, not their ultimate destination. As the S&L scandal memorably showed, deposit brokers can sweep up money in one state and deposit it in another, while loan brokers, in turn, divert it elsewhere. This mobility is worth stressing, for it was fear of local money being channeled elsewhere that lay behind historic resistance to national banks.


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Are community banks then extinct? In the long run, probably yes. As large out-of-state banks invade their territory, many will merge with rival banks. Those who can survive and meet high capital standards, however, should not be stampeded into mergers. Rather, there should be a regulatory bias toward large, geographically diverse banks. In fact, the Federal Reserve Board should revive a beneficial taboo violated in 1988 when Bank of New York took Irving Trust by main force. Until that time, hostile raids were considered taboo in banking, for fear that an abrupt change of ownership would shake depositor confidence. Resurrecting that taboo could preserve small, well-run banks. It is also extremely important that expanding banks use real capital, not junk bonds or associated funny money that would make the move toward interstate banking a replay of the S&L disaster.

Most banks that now operate in several states favor interstate branching to economize on overhead; they would gladly dispense with separate boards of directors in each state. Yet some super-regionals, such as Ohio's Bane One, maintain separate charters in each state to win support and assuage local anxiety about being ruled by faraway banks. This suggests a way to consolidate the system and preserve community values.

Most community groups oppose national banks -- a natural but short-sighted fear. Small-town businessmen pride themselves on their bank connections -- until their local banks fail. Witness New Hampshire where all five leading banks are today in trouble. Community banks have had a checkered history. They have often been a haven for local wheeler-dealers. Even when animated by noble causes, they sometimes lack the financial resilience to deliver on their promise. Last November, Freedom National Bank of Harlem -- created in the 1960s to introduce a minority-controlled bank in Harlem -- failed after a drop in local real estate prices. Thirty community agencies with deposits above the $100,000 insurance limit may recover only fifty cents on the dollar. It is better to require lending to poor neighborhoods through such measures as the 1977 Community Reinvestment Act than to maintain a ramshackle banking system to that end. As for consumer groups worried that national banking will mean higher fees, they have misread the past decade. Banks have hiked up fees and fattened loan spreads in direct proportion to declining profitability.

Other industrial countries have operated with far fewer banks and no discernible loss of liberty. In Germany the top eight banks control half of all bank assets, while it takes the top thirteen banks to reach that level in Japan and the top thirty-five in the U.S. Great Britain, which relies on only thirteen banks, hasn't had a major bank failure in this century. Six banks control 90 percent of Canadian banking assets. The need to maintain fifty separate systems in the U.S. stems from an outmoded fear of concentrated financial power.

As suggested earlier, the Glass-Steagall Act has produced some unintended results. Instead of democratizing Wall Street and allowing new firms to challenge J.P. Morgan et al., it actually saved the old guard. By the late 1920s, securities affiliates of commercial banks were overtaking old-line private partnerships. By abolishing this threat, Glass-Steagall kept alive the small partnerships for another forty years, creating a tidy cartel of multimillionaire investment bankers.

Those investment banks issuing dire warnings about Glass-Steagall's demise have often violated its spirit. During the 1980s merger boom, the old-line investment houses searched for ways to compete with upstart Michael Milken's gigantic junk-bond engine. They found the answer by raising huge "bridge loans" for raiders from their own capital. They would subsequently reduce their dangerous temporary exposure by floating junk bond issues. This was both a conflict of interest and a form of commercial banking. It is hypocritical for these houses to warn about mixing lending and securities work when they have mingled the two on a uniquely dangerous scale.

The distinction between commercial and investment banking has become doubly artificial through a phenomenon called "securitization." Instead of holding loans to term, banks now often originate loans, package them into bonds, and sell them through investment banks. In 1990 half of all newly issued securities were bundled bank loans, fusing together the financial hemispheres pried apart in 1933. Glass-Steagall has become a Berlin Wall running through a single city of finance.

Under the Treasury proposal, to enter the securities business banks will have to set up separately capitalized affiliates, shielded from the bank by "firewalls." One suspects there will be future shenanigans. Securities prospectuses can mitigate, but cannot eliminate, conflicts of interest. Tighter enforcement by both the Securities and Exchange Commission and the bank regulators can punish transgressors. As long as regulators are vigilant, it is better to run the risk of occasional misconduct than to imprison banks in an unprofitable business merely to avoid it.

The stress should be on how Glass-Steagall is abolished. Although underwriting may not be as risky as advertised, it does demand large initial investments of money and personnel. The government should permit only well-capitalized banks to take the risk, lest there be a blow-out such as occurred when banks flocked to the London securities market for the Thatcher government's "Big Bang" deregulation of 1986. British and foreign banks spent a fortune on traders and trading rooms, only to suffer huge losses during the subsequent war of attrition. The General Accounting Office has recommended that underwriting powers be granted on a case-by-case basis, an idea with merit.

Regulation and Supervision
A paradox conveniently forgotten by framers of the S&L disaster is that more entrepreneurial freedom for financial institutions -- "deregulation" -- logically requires more supervision. Financial competition can produce collective lunacy, especially now that deposit insurance has vastly expanded the money that can bankroll such lunacy. That is why Franklin Roosevelt demanded that deposit insurance be accompanied by a commensurate increase in oversight. Conservatives no less than liberals should welcome such supervision, for it permits competition to flourish without producing violent boom-and-bust cycles.

The Reagan administration confused regulation with supervision. It pruned the army of S&L examiners when it should have been expanded. Some busted thrifts had not been examined in three years. While commercial bank regulators boast of superior vigilance, a 1988 congressional study of 189 failed banks found that 79 had not been examined for a year and 29 for three years before they failed. Unless Congress mandates annual, on-site examination of all banks, any reform will boomerang.

A superfluous debate has raged over whether regulation is best done through market incentives or regulatory curbs. Why not opt for what engineers call "redundant" safety systems and use both? A well-designed banking system would require less first aid and permit a degree of diversification impossible for small banks. Regulators could enforce stricter limits on how much banks could lend to a single country, company, or industry. With Latin debt in the Carter years and commercial property and leveraged buyout debt under Reagan, regulators winked as bankers bet the store on single, high-risk sectors.


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When trouble develops, automatic mechanisms or "trip wires" should force early change upon bank management. The most efficient method is to require remedial action when a bank's capital-to-assets ratio falls below a certain minimum. These should be ironclad standards, impervious to political tampering. One reason American rescues prove so costly is that regulators wait until banks are broke before acting, saddling taxpayers with the full bailout cost. Bank regulators should be more like doctors and less like fancy morticians.

In other countries, bank failures are seen as shameful confessions of regulatory incompetence. Long before a bank fails, the Bank of England will shuffle executives or demand dividend cuts. The Bank of Japan will merge a shaky ailing bank with stronger rivals or have other local banks organize aid. Widespread bank failures should be automatic grounds for dismissal of regulators. Such foreknowledge would stiffen the spines of regulators when dealing with bankers and politicians.

The Treasury program would reduce regulatory agencies from four into two, diminishing the segmentation of regulators. The Federal Reserve Board would supervise state-chartered banks, while a new Federal Banking Agency in the Treasury would preside over nationally chartered banks and thrifts; the FDIC would lose out. The impulse is good, the execution flawed. The House Banking Committee chairman, Henry B. Gonzalez, has favored a single regulator, responsible to Congress, which sounds like a good idea so long as individual congressmen cannot tamper with investigations. The new agency should be accountable to Congress about the general health of banks, but not about specific investigations in progress.

In moving toward bank-based holding conglomerates, it will be necessary to regulate by function -- lending, securities underwriting, insurance, etc. -- rather than by institution. With the mounting overlap of the separate financial sectors, banking regulation can only be as effective as other financial regulation. If, for example, insurance commissioners permit insurance companies to leap into speculative property deals and junk bonds, as they did in the 1980s, it will only stimulate dangerous imitation by banks.

Here again, blending the activities permitted diverse financial institutions logically demands more coherent regulation.

Deposit Insurance
After the New Deal, liberals glorified deposit insurance. The pre-1980 experience confirmed that insurance can instill confidence in banks. But recent experience shows that it can also loosen market discipline and encourage looting, especially when accompanied by brokered deposits, lax supervision, and lenient capital standards. The New York Times recently made a quixotic editorial plea to insure all deposits, however gigantic. The real beneficiaries would be the financial swindlers.

The Treasury plan would merely plug a loophole that allows a wealthy couple with children to deposit over a million dollars in insured joint accounts at a bank. Under the new proposal, an individual could have one $100,000-account per bank, with another $100,000 for a retirement account. But well-heeled individuals could simply duplicate the set-up at other banks. The best reform would permit each individual only one insured account anywhere in the system. Only by trimming deposit insurance can regulators insist that large depositors be more prudent about where they bank and stop the syndrome of risky lending leading to more failures, higher insurance premiums, lower bank profits, and another competitive edge for nonbanks.

Over the past year, federal regulators have reaffirmed the doctrine that some banks are "too big to fail" -- i.e., that the government will make good on even uninsured deposits if the failed bank is large enough. This policy is now consolidating the banking system, but in a way that unfairly penalizes small banks and fosters new perils. Government cannot renounce the policy outright, because everyone knows that Washington would never let a Citibank fail. But it can penalize large depositors who keep their money in banks that pay for above-market interest rates with risky loans. One sensible idea is the "haircut" -- large depositors in bailed out banks would get, say, 90 percent of their money back, but not 100 percent. This would force sophisticated depositors to weigh reward against risk, and appropriately punish speculative banks with outflows of deposits.

Banking and Commerce
Ending the most powerful taboo, the Treasury plan proposes to let industrial corporations buy banks. The relationship between banks and corporations has long been the most vexing question in American financial history. Not surprisingly, this controversial idea has stirred fears of a corpora tist state, marked by cartels and sinister interlocks between banks and corporations on the German or Japanese model.

The fears are belated, for commercial companies have already invaded the non-bank arena as an outgrowth of their everyday businesses. In 1911 Sears Roebuck began financing customer purchases. Today its financial empire embraces Allstate insurance, Dean Witter brokerage, and Coldwell Banker real estate company. Similarly, General Electric's financial operation -- begun to finance toasters and refrigerators -- boasts $64 billion in assets, including the world's fourth-largest non-life insurance company. If rated as a commercial bank, it would stand eighth beside Manufacturers Hanover. General Motors controls one of the top three mortgage banks. Ford Motor owns a major thrift. During the past year, AT&T has enlisted over eight million customers for its credit card, while IBM offers a money-market fund. Nine of the top fifteen investment banks are owned by industrial or nonbank financial firms. The list can be multiplied endlessly. Recently, the FDIC auctioned off the failed Bank of New England to Fleet/Norstar, which brought in Kohlberg, Kravis, Roberts, a Wall Street industrial holding company, as its partner.

So the question isn't whether industrial companies should enter finance -- they're there -- but whether they can be lured into the commercial bank tent. If nonbanks owned by industrial companies cannot be subjected to the same regulatory discipline as banks -- that is, if the regulatory sphere cannot be widened -- bank regulation will be difficult. In a competitive system, risky unregulated lending places pressure on sound bankers to respond in kind. Right now, many nonbanks, such as those owned by GE and Westinghouse, are suffering from bad loans for commercial property and leveraged buyouts, suggesting that they could benefit from better government oversight. But only a broader array of legitimate banking powers will attract them into accepting bank charters, with their associated regulatory discipline and depository insurance costs.

To prevent an industrial company from buying a bank just to milk it, the federal government can outlaw business between the parent company and its bank subsidiary. Some have also expressed concern that an industrial parent company might use its bank to sabotage a competitor. But with the current explosion of financial intermediaries, individual banks seldom have such life-and-death power over major corporations. Of course, such temptations are endemic to banking; that is precisely why strong regulation is so necessary.


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The reverse situation -- banks buying stakes in industrial companies -- is a different story. When companies buy banks, they use shareholder money and enter a regulated world. When banks buy companies, they use insured deposits and enter a realm of freedom, inviting possible abuse of taxpayer money. Some liberal and conservative theorists claim that by buying large stakes, banks can provide patient, long-term money for industry. They note that in Germany and Japan, where banks hold large blocks of shares, companies were largely immune to corporate raids of the 1980s that distracted management, derailed research plans, and loaded companies with debt. In the United States and Britain, with their separation of industry and finance, companies were vulnerable to the depredations of raiders.

In the future, however, it seems more likely that industrial companies will prop up banks than the reverse. Many multinational corporations now have higher ratings and can raise money more cheaply than their bankers, subverting the traditional relationship. (Only one American bank, Morgan Guaranty Trust, retains a Triple-A rating.) This change in relative financial power undermines the historic rationale for companies seeking bank patronage. The German and Japanese systems will probably evolve in the direction of the Anglo-American system. In Germany a commercial paper market is beginning to liberate companies from dependence on bank debt. In Japan, in striking proof of the power shift, troubled banks are seeking rescue money from cash-rich industrial companies such as Nissan, Sony, and Toyota.

In part, this shift reflects temporary factors, namely the aftermath of the debt-riddled 1980s; the relationship was similarly reversed in the 1930s. Yet if one surveys the vast sweep of American financial history, the irreversible demotion of the banker's role becomes unmistakable. The old Wall Street tycoons, with their yachts and private railroad cars, had power over fledgling industrial companies that needed a banker's imprimatur to sell their debt. For these companies, the Morgan name was better known than their own.

Today, an IBM or AT&T no longer needs a banker's seal of approval to reassure investors. Large corporations employ dozens of bankers and can play them off against each other. It is telling that the impetus behind the plan to allow industrial companies to own banks comes from the need to replenish depleted bank capital. Industrial companies today enjoy the upper hand in the relationship.

The past decade confirms that banks should not be allowed to own industrial companies. In the "merchant banking" fad of the 1980s investment banks, weakened in their traditional role as agents for companies, tried to act as "principals." They bet their own money on takeovers, financed corporate raiders or even became raiders themselves in the leveraged buy-out craze. Far from resulting in far-seeing management, such financial manipulation led to quick company bust-ups. In the fashion exposed by Louis Brandeis in his polemic against Morgan control of the New Haven Railroad, bankers squeezed companies for unnecessary financing and inflated fees. All of this produced mayhem, not stability. It is a history we don't need to repeat, especially since American antitrust law would create endless problems for banks investing in companies in the same or related industries.

The American banking system is not serving the needs of consumers, communities, America's global competitiveness, or economic stability. As currently regulated, banks are obsolete institutions. Unless granted broader powers, they will self-destruct or give way to nonbanks. Is the situation then hopeless? Not at all. By granting banks the added ability to sell insurance and mutual funds as well as offer deposits, Congress would assure banks more stability. Then their major liability -- their expensive brick-and-mortar branch networks -- becomes their major asset as they have an array of profitable products to put into the pipeline.

So do banks need regulation or deregulation? They need deregulation, if that is defined as granting broader powers. But they need more regulation, if that is defined as stronger supervision. The 1980s were a wonderful laboratory in this respect. The S&Ls received new freedom and less supervision and they jumped straight off a cliff. The commercial banks, meanwhile, were so tightly regulated that they choked to death. Some congressional Democrats, unfortunately, would like to replenish the deposit insurance fund and tighten regulation but avoid structural reform. This would merely generate more bank failures and postpone the day of reckoning.

We should move beyond a freewheeling "entrepreneurial" approach that has permitted bank charters to be obtained with little capital or banking experience. Instead, we should encourage a "custodial" approach in which banking is regarded as a profession, a sacred stewardship, a public trust. Banking is not a business like any other. It should not operate according to Schumpeter's principles of creative destruction or Darwin's survival of the fittest. Banks should be gyroscopes that keep the economy on a safe, steady course. They should be granted broader powers precisely so that they can act responsibly and recapture their blue-chip customers. Otherwise they will go on reproducing disaster and accentuating boom-and-bust cycles. Perhaps, after two bloody centuries of failures, we can all awaken from the nightmare of American banking history.

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