The banking crisis isn't over

USA Today (Society for the Advancement of Education), Sept, 1994 by Ronnie J. Phillips

THE IMMEDIATE reaction to the mention of a "banking crisis" these days is likely to be: What crisis? After all, banks are reporting record profits, failures are down, and the Clinton Administration even was able to find budget savings because less would be needed for the bank insurance fund for bailouts of failed financial institutions. So how can there be a banking crisis?

The answer is that the term, as used here, does not refer to an immediate danger that 1,000 banks will go under, as was projected by a now infamous report released in 1992 by the Washington Post. Instead, the crisis referred to is the possibility that banks are dinosaurs whose time is past and nothing can be done to save them because the forces that have sealed their fate are so strong and immutable that to oppose them would be the height of folly. A 1993 issue of Time carried an article with the ominous title: "Are Banks Obsolete?" The fear among many, including bankers, is that the answer is a resounding yes, and that the only issue left is the scenario for their final withering away.

Historically, the nation has relied on banks to serve a dual function in the economy--to provide a form of money that in many ways was more convenient than currency in making payments for goods and services and to channel funds from savers to borrowers. Although they have done this for most of U.S. history, advances in technology and the advent of mutual funds in recent years have raised basic questions about whether banks can continue to perform this dual function. A safe and stable payments system is crucial to the smooth functioning of the financial system. However, the provision of Federal deposit insurance as a means of guaranteeing a safe payments system has undesirable implications for the lending activity of banks. The possibility of fundamental change in their dual role has connotations for the payments system, lending to small firms, and the conduct of monetary policy by the Federal Reserve.

If banks are obsolete, why is this the case? Alex Pollock, president and CEO of the Federal Home Loan Bank of Chicago, when speaking before a group of bankers from nationally chartered banks, asks them what national bankers would have considered to be their fundamental activity 100 years ago. The answer is that the primary function of national banks then was to issue national bank notes. Against the issuing of the banknotes, they had to hold 111% in government securities. Originally, national banks were prohibited from making real estate loans, though subsequent legislation relaxed the ban. Today, they no longer issue national bank notes and face the same regulations of their activities that confront the state chartered institutions (though not necessarily those of bank holding companies). The activities of national banks thus have been altered dramatically in the past century, driven by market forces, technological and geographical changes, and the legislative response.

National banks no longer are restricted to purely a role in the payments system. They now are a conduit between borrower and lender, as are state chartered banks. Because of the lack of adequate lending institutions and the convenience of banks, they were allowed to carry out this dual function. The problem is that a payments system works most efficiently when paper money exchanges at its stated face value. In colonial days, when bills of credit circulated as money, the inconvenience of calculating their value led to the issuing of bills of credit that were redeemable on demand--i.e., banknotes. There is a basic balance sheet problem when issuing a non-commodity money (banknotes, deposits). In order to maintain a stable face value, the assets backing the money also must be stable in value, so national banknotes were backed by government securities. It was recognized in 1863--which seems to have been forgotten in recent years--that many real estate loans are not stable assets and therefore inappropriate to back money. The banking legislation of the 1930s, rather than adopting the National Bank Act solution, created Federal deposit insurance to provide a safe payments system.

New Deal banking legislation

Prior to the Federal guarantee of deposits, if a bank failed, owners of equity lost their investment and, if necessary, depositors might have their accounts redeemed in something less than par value. Another feature of the banking system before the 1930s was double liability. If you owned stock in the bank, say in the par value of $1,000, then, if the bank had bad loans and was in danger of failing, you were liable to come up with $2,000 on demand of its creditors.

How closely would you scrutinize your bank if there was no deposit insurance and double liability? You probably would spend time trying to find out whether or not the bank was a safe place for your money, or, if you were an equity owner, you would seek assurance that the rate of return was adequate to compensate you for risk. You probably would shop as carefully for a bank as for a car or other items that represent a large share of your net wealth. If you were an owner, you would want to make sure your banker was not playing fast and loose with your money because of the double liability.