No wonder banks fail
Wriston, Walter B.
1990
No wonder banks fail
No wonder banks fail
The first rule of sound banking is never to put all your eggs in one basket. Since no one is smart enough to know where trouble will strike next, or in what form, diversification of assets is the only sound course. One would think that legislation governing banking would foster this time-tested concept. The reverse is true. A system designed in the heady first 100 days of the Roosevelt administration is no more appropriate to conditions in the financial markets of 1990 than the air quality standards that were accepted then are appropriate today. Worse, the network of laws and regulations that exists today actually fosters bank failures. | |
True diversification takes many forms, but an obvious one is geographic diversity. If a bank is limited to making loans in its own neighborhood and that neighborhood goes downhill, so will the bank. A small bank (or a big one) in an agricultural area with 100% of its loans to farmers in its area will be in trouble if the crop should fail. All this is, or should be, self-evident, but American banking laws are currently designed to cause bank failures by prohibiting American (but not foreign) banks to branch across the common market called the U.S. and in some states until recently not to branch at all! | |
It is interesting to note that our neighbor to the north, Canada, suffered no big bank failure during the Great Depression -- a period when the U.S. lost 5,000 banks. Canada permitted nationwide banking, and when the crops were scarce in Manitoba, the fish were biting in Nova Scotia. No chain bank had all its loans in one geographic basket. | |
The U.S. could learn from that example. Since the present American banking system violates the first rule of banking, preserving the present legal structure serves only to produce bank failures. While those banks that are established in a certain location and thus enjoy an area monopoly dislike "outside" bankers invading "their market," present law facilitates the concentration of assets. Indeed, by its Community Redevelopment Act, which orders banks to lend locally, the law actually mandates concentration. | |
Part two of the lesson on concentration of assets concerns the kinds of assets that make up the omnibus figure on a balance sheet -- loans to businesses, to governments and to individuals. Does a bank's income come only from interest on loans and securities, or does it flow from diversified financial products, like life or casualty insurance premiums, underwriting fees and commissions or other financial services? Once again we find a system designed to defeat sound management. Just as the 1927 McFadden Act frustrated the geographic dispersal of deposits and assets by forbidding banking across state lines, so the 1933 Glass-Steagall Act has, over the years, fostered product monopolies by forbidding banking across product lines. | |
Taking only the smallest literary license, the great Deutsche Bank in Germany could be described as a closed-end mutual fund, as it owns the capital stock of dozens of great industrial firms. Finance and commerce are not separated, but merged. By blocking American banks -- but not General Electric Capital, Ford Credit or General Motors Acceptance Corp. -- from diversifying their product line, the system once again forces banks not only to put all their eggs into one basket, but to fill the basket with the same kind of eggs. If banks did this as a result of a management decision, instead of by law, any alert regulator would severely and justifiably criticize the practice as unsafe and unsound. Perhaps this distinction too has outlived its usefulness, as some in the Bush administration seem to think. | |
The third way in which the present system of laws and regulations works toward producing bank failures is its depressing effect on bank earnings. It is no arcane secret that businesses that earn money survive and that those that don't fail. Banking laws should not prohibit banks from earning money on their assets. But the current system requires that American banks take a sizable chunk of their deposits, currently around 10% for demand deposits, and place them either in their own vaults in cash or at zero interest in an account with the Federal Reserve. | |
These required reserves amount in the aggregate to about $63 billion on which no interest is paid. No other business in the world labors under such a handicap. The opportunity cost to the industry approximates $5 billion. The Federal Reserve, having thus gotten some of its inventory for nothing, invests these funds in government bonds and collects the interest. Rather than return these earnings to the banks' shareholders, the Fed sends the money to the Treasury. Depending on the interest rate of the moment, the sum lost to shareholders every year comes to about $2.6 billion. All the insured American banks together earned just $15.7 billion last year, and that $2.6 billion is money that could and should be used to build bank earnings and capital. | |
Toward the end of his term, Federal Reserve Chairman Paul Volcker recommended that this $2.6 billion a year be returned to the banks. So far nothing has come of his suggestion, for this diversion of earnings is really a hidden tax, invisible to all but its victims. If this interest went to the owners of the deposits, a significant step would be taken toward rebuilding bank capital. In addition to these lost earnings, banks will pay the Federal Deposit Insurance Corp. $5 billion next year, or almost a third of their net earnings in 1989. | |
Although every bank that has failed since the Great Depression has exceeded the capital ratios set by the bank regulators, capital strength is nevertheless an important element in the banking picture. | |
The payment of interest on reserve balances to the bank would in and of itself improve capital adequacy; the earnings so generated would flow into the banks' capital accounts, and also would improve bank earnings thus making it easier to sell bank stock in the marketplace. Obviously securities of those companies that earn a good return are more attractive to an investor than those that do not. By improving bank earnings, the market for bank capital will be enhanced. As an added twist, some portion of this refunded interest might be directed to the FDIC, on some agreed schedule, to shore up that fund, once again without taxpayer assistance. | |
No one in public office would consciously design a system to produce bank failures, but by not changing a system that is almost 60 years old, the U.S. is faced with a structure bound to produce that unhappy result. | |
Mr. Wriston was chairman of Citicorp from 1967 until 1984. | |