Alexander Hamilton’s Financial Plan

A major problem facing the first federal government was how to deal with the financial chaos created by the American Revolution. States had huge war debts. There was runaway inflation. Almost all areas of the economy looked dismal throughout the 1780s. Economic hard times were a major factor creating the sense of crisis that produced the stronger central government under the new Constitution.

George Washington chose ALEXANDER HAMILTON, who had served with him throughout the Revolutionary War, to take on the challenge of directing federal economic policy as the treasury secretary. Hamilton was a self-made man whose ambition fueled tremendous success. Born on the British island of Nevis in the West Indies, the second of two boys. His father James is a Scottish trader of noble ancestry. His mother Rachel Faucett, of French descent, is still married to another man at the time. Rachel was a shopkeeper, he learned his first economic principles from her and went on to apprentice for a large mercantile firm. In 1774, Hamilton goes to New York to begin studies at King's College (which will become Columbia University). Hamilton became captain of the 1st Battalion, 5th Field Artillery Unit. (Today, the unit is the oldest still existing in the United States Army and the only one remaining from the Revolution.) Hamilton conducts himself with skill during General George Washington's subsequent retreat through New York, and draws the Continental Army commander's attention. From these modest origins, Hamilton would become the foremost advocate for a modern capitalist economy in the early national United States.

Hamilton's influential connections were not just with Washington, but included a network of leading New York merchants and financiers. His 1780 marriage to ELIZABETH SCHUYLER, from a wealthy Hudson River valley land holding family, deepened his ties to rich and powerful leaders in New York. His innovative financial policies helped overcome the fiscal problems of the CONFEDERACY, and also benefited an economic elite with which he had close ties.

The first issue that Hamilton tackled as Washington's SECRETARY OF THE TREASURY concerned the problem of PUBLIC CREDIT. Governments at all levels had taken on so much debt during the Revolution. The commitment to pay them back was not taken very seriously. By the late 1780s, the value of such public securities had plunged to a small fraction of their face value. In other words, state IOU's — the money borrowed to finance the Revolution — were viewed as nearly worthless.

Hamilton issued a bold proposal. The federal government should pay off all CONFEDERATION (state) debts at full value. Such action would dramatically enhance the legitimacy of the new central government. To raise money to pay off the debts, Hamilton would issue new SECURITIES (bonds). Investors who had purchased these public securities could make enormous profits when the time came for the United States to pay off these new debts.

Hamilton's vision for reshaping the American economy included a federal charter for a national financial institution. He proposed a BANK OF THE UNITED STATES. Modeled along the lines of the Bank of England, a central bank would help make the new nation's economy dynamic through a more stable paper CURRENCY.

The central bank faced significant opposition. Many feared it would fall under the influence of wealthy, urban northeasterners and speculators from overseas. In the end, with the support of George Washington, the bank was chartered with its first headquarters in Philadelphia.

The third major area of Hamilton's economic plan aimed to make American manufacturers self-sufficient. The American economy had traditionally rested upon large-scale AGRICULTURAL EXPORTS to pay for the import of British MANUFACTURED GOODS. Hamilton rightly thought that this dependence on expensive foreign goods kept the American economy at a limited level, especially when compared to the rapid growth of early industrialization in Great Britain.

Rather than accept this condition, Hamilton wanted the United States to adopt a MERCANTILIST economic policy. This would protect American manufacturers through direct government SUBSIDIES (handouts to business) and TARIFFS (taxes on imported goods). This PROTECTIONIST policy would help fledgling American producers to compete with inexpensive European imports.

Hamilton possessed a remarkably acute and self-serving economic vision. His aggressive support for manufacturing, banks, and strong public credit all became central aspects of the modern capitalist economy that would develop in the United States in the century after his death. Nevertheless, his policies were deeply controversial in their day.

Many Americans neither like Hamilton's elitist attitude nor his commitment to a British model of economic development. His pro-British foreign policy was potentially explosive in the wake of the Revolution. Hamilton favored an even stronger central government than the Constitution had created and often linked democratic impulses with potential anarchy. Finally, because the beneficiaries of his innovative economic policies were concentrated in the northeast, they threatened to stimulate divisive geographic differences in the new nation.

Regardless, Hamilton's economic philosophies became touchstones of the modern American capitalist economy.

Thomas Jefferson’s Opposition to Hamilton’s Financial Plan

The 1790s brought extraordinary divisions to the forefront of American life and politics. Strong differences about how best to maintain the benefits of the Revolution lay at the center of these conflicts. Hamilton's economic policies were among the earliest sources of tension. They sparked strong reactions not only from elected officials and ordinary farmers, but even split Washington's cabinet.

Thomas Jefferson, who was the secretary of state at the time, thought Hamilton's plans for full payment of the public debt stood to benefit a “corrupt squadron of paper dealers.” To Jefferson, SPECULATION in PAPER CERTIFICATES threatened the virtue of the new American Republic. Even Madison, who had worked closely with Hamilton in co-authoring The Federalist Papers, thought the public debt repayment plan gave too big a windfall to wealthy financiers.

As a counter-measure Madison proposed that Congress should set aside some money for the original owners of the debts who tended to be ordinary Americans and not new investors and speculators.

On a pragmatic level Madison's idea would have been difficult to implement. Nearly half the members of Congress invested in public securities. They stood to benefit financially from Hamilton's plan. Its passage was doubly assured.

Hamilton's successful bid to CHARTER a national Bank of the United States also brought strong opposition from Jefferson. Their disagreement about the bank stemmed from sharply opposed interpretations of the Constitution. For Jefferson, such action was clearly beyond the powers granted to the federal government. In his “STRICT INTERPRETATION” of the Constitution, Jefferson pointed out that the tenth amendment required that all federal authority be expressly stated in the law. Nowhere did the Constitution allow for the federal government to create a bank.

Hamilton responded with a “LOOSE INTERPRETATION” that allowed such federal action under a clause permitting Congress to make “all Laws which shall be NECESSARY AND PROPER.”

Neither side was absolutely right. The Constitution needed INTERPRETATION. In this difference, however, we can see sharply contrasting visions for the future of the republic.

Opposition to Hamilton's financial policies spread beyond the cabinet. The legislature divided about whether or not to support the Bank of the United States. This split in Congress loomed as a potential threat to the union because northern representatives overwhelmingly voted favorably, while southerners were strongly opposed. The difference stemmed from significant economic differences between the sections. Large cities, merchants, and leading financiers were much more numerous in the north and stood to benefit from Hamilton's plans.

Keen observers began to fear that sharp sectional differences might soon threaten the union. Indeed, the Bank ultimately found support in Congress through a compromise that included a commitment to build the new FEDERAL CAPITAL on the banks of the Potomac River. In part this stemmed from the fact that southern states such as Virginia had already paid off their war debt and stood to gain nothing from a central bank. While most of the commercial beneficiaries of Hamilton's policies were concentrated in the urban northeast, the political capital of WASHINGTON, D.C. would stand in the more agricultural south. By dividing the centers of economic and political power many hoped to avoid a dangerous concentration of power in any one place or region.

The increasing discord of the early 1790s pointed toward an uncertain future. The Virginian Jefferson and the New Yorker Hamilton serve as useful figureheads for the opposing sides. While Hamilton was an adamant elitist whose policies favored merchants and financiers, Jefferson, though wealthy, favored policies aimed toward ordinary farmers.

Their differences also extended to the branch of government that each favored. Hamilton thought a strong executive and a judiciary protected from DIRECT POPULAR INFLUENCE were essential to the health of the REPUBLIC. By contrast, Jefferson put much greater faith in democracy and felt that the truest expression of republican principles would come through the legislature, which was elected directly by the people. Their differences would become even sharper as the decade wore on.

Proto Banks

Banks have been around since the first currencies were minted, perhaps even before that, in some form or another. Currency, particularly the use of coins, grew out of taxation. In the early days of ancient empires, a tax of one healthy pig per year might be reasonable, but as empires expanded, this type of payment became less desirable. Additionally, empires began to need a way to pay for foreign goods and services, with something that could be exchanged more easily. Coins of varying sizes and metals served in the place of fragile, impermanent paper bills.

These coins, however, needed to be kept in a safe place. Ancient homes didn't have the benefit of a steel safe, therefore, most wealthy people held accounts at their temples. Numerous people, like priests or temple workers whom one hoped were both devout and honest, always occupied the temples, adding a sense of security. There are records from Greece, Rome, Egypt and Ancient Babylon that suggest temples loaned money out, in addition to keeping it safe. The fact that most temples were also the financial centers of their cities, is the major reason they were ransacked during wars.

Coins could be hoarded more easily than other commodities, such as 300-pound pigs, so there emerged a class of wealthy merchants who took to lending these coins, with interest, to people in need. Temples generally handled large loans, as well as loans to various sovereigns, and these new money lenders merchants took up the rest.

The First Bank

The Romans took banking out of the temples and formalized it within distinct buildings. During this time moneylenders still profited, as loan sharks do today, but most legitimate commerce, and almost all governmental spending, involved the use of an institutional bank. Julius Caesar, in one of the edicts changing Roman law after his takeover, gives the first example of allowing bankers to confiscate land in lieu of loan payments. This was a monumental shift of power in the relationship of creditor and debtor, as landed noblemen were untouchable through most of history, passing debts off to descendants until either the creditor's or debtor's lineage died out.

The Roman Empire eventually crumbled, but some of its banking institutions lived on in the form of the papal bankers that emerged in the Holy Roman Empire, and with the Knights Of The Temple during the Crusades. Small-time moneylenders that competed with the church, were often denounced for usury.

Eventually, the various monarchs that reigned over Europe noted the strengths of banking institutions. As banks existed by the grace, and occasionally explicit charters and contracts, of the ruling sovereign, the royal powers began to take loans to make up for hard times at the royal treasury, often on the king's terms. This easy finance led kings into unnecessary extravagances, costly wars and an arms race with neighboring kingdoms that lead to crushing debt. In 1557, Phillip II of Spain managed to burden his kingdom with so much debt, as the result of several pointless wars, that he caused the world's first national bankruptcy, as well as the second, third and fourth, in rapid succession.

Adam Smith and Modern Banking

Banking was already well established in the British Empire when Adam Smith came along in 1776 with his "invisible hand" theory. Empowered by his views of a self-regulated economy, moneylenders and bankers managed to limit the state's involvement in the banking sector and the economy as a whole. This free market capitalism and competitive banking found fertile ground in the New World, where the United States of America was getting ready to emerge.

In the beginning, Smith's ideas did not benefit the American banking industry. The average life for an American bank was five years, after which most bank notes from the defaulted banks became worthless. These state-chartered banks could, after all, only issue bank notes against gold and silver coins they had in reserve.

Alexander Hamilton, the secretary of the Treasury, established a national bank that would accept member bank notes at par, thus floating banks through difficult times. This national bank, after a few stops, starts, cancellations and resurrections, created a uniform national currency and set up a system by which national banks backed their notes by purchasing Treasury securities, thus creating a liquid market. Through the imposition of taxes on the state chartered banks, the national banks pushed out the competition.

The damage had been done already, however, as average Americans had already grown to distrust banks and bankers in general. This feeling would lead the state of Texas to actually outlaw bankers, a law that stood until 1904.

Merchant Banks

Most of the economic duties that would have been handled by the national banking system, addition to regular banking business like loans and corporate finance, fell into the hands of large merchant banks, because the national banking system was so sporadic. During this period of unrest that lasted until the 1920s, these merchant banks parlayed their international connections into both political and financial power. These banks included Goldman and Sachs, Kuhn, Loeb, and J.P. Morgan and Company. Originally, they relied heavily on commissions from foreign bond sales from Europe, with a small backflow of American bonds trading in Europe. This allowed them to build up their capital.

At that time, a bank was under no legal obligation to disclose its capital reserve amount, an indication of its ability to survive large, above-average loan losses. This mysterious practice meant that a bank's reputation and history mattered more than anything. While upstart banks came and went, these family-held merchant banks had long histories of successful transactions. As large industry emerged and created the need for corporate finance, the amounts of capital required could not be provided by any one bank, so IPOs and bond offerings to the public became the only way to raise the needed capital.

The public in the U.S. and foreign investors in Europe knew very little about investing, due to the fact that disclosure was not legally enforced. Therefore, these issues were largely ignored, according to the public's perception of the underwriting banks. Consequently, successful offerings increased a bank's reputation and put it in a position to ask for more to underwrite an offer. By the late 1800s, many banks demanded a position on the boards of the companies seeking capital, and, if the management proved lacking, they ran the companies themselves.

Morgan and Monopoly

J.P. Morgan and Company emerged at the head of the merchant banks during the late 1800s. It was connected directly to London, then the financial center of the world and had considerable political clout in the United States. Morgan and Co. created U.S. Steel, AT&T and International Harvester, as well as duopolies and near-monopolies in the railroad and shipping industries, through the revolutionary use of trusts and a disdain for the Sherman Anti-Trust Act.

Although the dawn of the 1900s had well-established merchant banks, it was difficult for the average American to get loans from them. These banks didn't advertise and they rarely extended credit to the "common" people. Racism was also widespread and, even though the Jewish and Anglo-American bankers had to work together on large issues, their customers were split along clear class and race lines. These banks left consumer loans to the lesser banks that were still failing at an alarming rate.

The Panic of 1907

The collapse in shares of a copper trust set off a panic that had people rushing to pull their money out of banks and investments, which caused shares to plummet. Without the Federal Reserve Bank to take action to calm people down, the task fell to J.P. Morgan to stop the panic, by using his considerable clout to gather all the major players on Wall Street to maneuver the credit and capital they controlled, just as the Fed would do today.

The End of an Era

Ironically, this show of supreme power in saving the U.S. economy ensured that no private banker would ever again wield that power. The fact that it took J.P. Morgan, a banker who was disliked by much of America for being one of the robber barons with Carnegie and Rockefeller, to do the job, prompted the government to form the Federal Reserve Bank, commonly referred to today as the Fed, in 1913. Although the merchant banks influenced the structure of the Fed, they were also pushed into the background by it.

Even with the establishment of the Federal Reserve, financial power, and residual political power, was concentrated in Wall Street. When the First World War broke out, America became a global lender and replaced London as the center of the financial world by the end of the war. Unfortunately, a Republican administration put some unconventional handcuffs on the banking sector. The government insisted that all debtor nations must pay back their war loans, which traditionally were forgiven, especially in the case of allies, before any American institution would extend them further credit.

This slowed down world trade and caused many countries to become hostile toward American goods. When the stock market crashed in on Black Tuesday in 1929, the already sluggish world economy was knocked out. The Federal Reserve couldn't contain the crash and refused to stop the depression; the aftermath had immediate consequences for all banks. A clear line was drawn between being a bank and being an investor. In 1933, banks were no longer allowed to speculate with deposits and the FDIC regulations were enacted, to convince the public it was safe to come back. No one was fooled and the depression continued.

World War II Saves the Day

World War II may have saved the banking industry from complete destruction. WWII, and the industriousness it generated, lifted the American and world economy back out of the downward spiral.

For the banks and the Federal Reserve, the war required financial maneuvers using billions of dollars. This massive financing operation created companies with huge credit needs that in turn spurred banks into mergers to meet the new needs. These huge banks spanned global markets. More importantly, domestic banking in the United States had finally settled to the point where, with the advent of deposit insurance and mortgages, an individual would have reasonable access to credit.

Regulated Banking

During the 1970s, and indeed during all of the postwar period leading up to the 1970s, U.S. commercial banking was a protected industry. Government regulations shielded banks from geographic competition, from product competition, and to a great extent from price competition. The McFadden Act of 1927 protected banks from outside competition by prohibiting interstate branch banking. Although the act permitted cross-border banking through multibank holding companies, these organizational structures required state approval, and during the 1970s none of the states approved. In addition to these interstate restrictions, most states imposed partial or blanket restrictions on intrastate branching. The Glass-Steagall Act of 1933 effectively isolated commercial banking as a separate and highly regulated financial sector and thus insulated banks from competition with investment banks, insurance companies, and brokerage firms. Moreover, depository institutions such as savings and loans and credit unions were not permitted to compete with banks for commercial loans. Regulation Q imposed interest rate ceilings on all deposits except for large negotiable CDs, effectively prohibiting price competition between banks for deposit accounts.

By 1980 there were still 14,434 chartered commercial banks in the United States. More than 97 percent of these commercial banks were “community banks” with less than $1 billion (2001 dollars) of assets, and these small banks accounted for about one-third of the industry’s total assets. The banking industry was the largest category of financial intermediary in the United States, with more than 35 percent of the nation’s intermediated assets (Federal Reserve Flow of Funds Accounts). The industry’s deposit franchise made it the dominant provider of transactions services through checkable deposit accounts, and banks were an extremely important investment vehicle for consumers through savings accounts and time deposit accounts. For example, consumers allocated approximately 23 percent of their assets to depository institutions in 1983 (the first year that these data were available from the Federal Reserve’s Survey of Consumer Finance). An important feature of a banks’ deposit franchise was their access to the payment system, which at the time was predominantly paper based. In a banking world emphasizing brick-and-mortar delivery, community banks enjoyed a competitive advantage in their local markets because regulation constrained brick-and-mortar entry by out-of-market banks, and automated teller machines (ATMs) were still in their infancy. In states that limited branch banking, this advantage was especially significant because large banks simply could not branch into local markets.

Loan markets were generally segmented during the 1970s, and in some lending markets banks (along with thrift institutions) were the dominant players. Banks and thrifts dominated the residential mortgage market. Mortgage holdings by insurance companies and finance companies were relatively small, and the mortgage securitization market was limited mostly to Ginnie Mae pass-throughs. With regard to consumer loans, consumer finance companies tended to attract the higher-risk and subprime borrowers, while banks, thrifts, and captive auto finance companies (for example, GMAC, Ford Motor Credit) tended to attract the prime consumer borrower. Again, because of the extensive limitations on branch banking, community banks’ power in local markets afforded them a competitive advantage in consumer lending over larger banks. Data from the Survey of Consumer Finance show that households obtained approximately 60 percent of their mortgage and consumer debt from depository institutions in 1983.

Commercial lending in the 1970s was segmented across financial institutions and within the banking industry. Large commercial banks made loans to business firms of all sizes and were the major source of short-term financing to large businesses. Small businesses are generally unable to get long-term financing other than to finance specific fixed assets such as equipment and real estate. Community banks, constrained by legal lending limits, focused on lending to smaller businesses. Community banks allocated between 20 and 30 percent of their loan portfolio to commercial loans, on average. Life insurance companies were also active in business finance, but their activities were confined to longer-term financing to medium-sized businesses and some large businesses.

Financial innovation and technological change

In the late 1960s and early 1970s money market interest rates regularly exceeded the Regulation Q ceiling on deposit interest rates. This gap became huge after the Federal Reserve changed its approach to monetary policy in 1979, with the ninety-day Treasury bill rate at one point exceeding the passbook savings account ceiling by more than 1,000 basis points. As a result, deposits flowed out of low-yielding bank deposits and into higher-yielding investments offered by nonbank institutions. The impact of this disintermediation was felt most acutely by smaller banks and thrifts that depended on the small retail deposits covered by Regulation Q, as opposed to large banks that relied more on large denomination CDs with interest rates that were set in competitive markets.

The threat from disintermediation was especially serious because retail customers were gaining increased access to alternatives to bank deposits for their liquid investments. The most salient change was the introduction of money market mutual funds (MMMFs) in 1971. Unlike existing large-denomination money market instruments such as negotiable CDs and commercial paper, MMMFs came in denominations affordable to households and small businesses; moreover, MMMFs had a big competitive advantage over Regulation Q–constrained bank deposits because they paid higher money market investment returns and allowed consumers check-writing privileges. As a result, MMMFs grew dramatically beginning in the late 1970s.

Later in the decade Merrill Lynch took this innovation one step further with its Cash Management Account by adding a third dimension, a brokerage account. Innovations elsewhere in the financial services sector, such as universal life insurance, which combined term life insurance with a money market–linked savings component, created additional alternatives to retail bank deposits.

Other innovations had an equally powerful impact on retail banking. One of the most important was the ATM, which reduced the cost of producing transactions services and made them more convenient. Banks had initially hoped that the ATM would be, as its name implies, a substitute for human tellers and perhaps even a partial substitute for bank branches. To the contrary, as the number of ATMs has increased, so has the number of bank branches; these unexpected trends imply that bank delivery systems have a variety of complex strategic characteristics, such as locations that provide customer convenience, revenue centers that generate fee income (for example, third-party ATM fees), and physical brick-and-mortar platforms for person-to-person contact and relationship building. In addition to the ATM, other alternatives to brickand- mortar banking began to appear in the 1970s and 1980s. Although fully transactional Internet banking did not appear until later, some banks began offering limited forms of computer banking in the 1980s. Customers with a computer and modem could pay bills and transfer money between accounts over telephone lines. Credit cards and debit cards expanded rapidly in the 1970s and 1980s, and although they are not generally thought of this way, these payment vehicles represented yet another alternative to the traditional bank delivery system.

Regulatory reaction to financial innovation and technological change

During the 1980s it became increasingly difficult to maintain a regulatory environment that could protect the banking industry from product competition, interregional competition, and interest rate competition while at the same time ensuring a vibrant and healthy banking industry. Market conditions and financial and technological innovation simply conspired against preservation of the old regime. Regulatory change became inevitable and necessary.

In some ways this change came quickly. For example, a period of high interest rates that began in 1979 led to the relatively rapid dismantling of Regulation Q, culminating with the passage of the Garn–St. Germain Depository Institutions Act in 1982, which, among other things, allowed thrifts to make commercial loans and thus compete more directly with community banks. The demise of the McFadden Act took longer. At the intrastate level, thirty-two states liberalized their in-state geographic restrictions on banking between 1980 and 1994. At the interstate level, states began to exploit the multibank holding company loophole in the McFadden Act in the early 1980s, entering into reciprocity agreements with each other that allowed cross-border bank ownership through multibank holding companies. By the end of the decade, all but six states allowed some sort of interstate banking, with most being part of large regional compacts.

Expansion of banking powers occurred at a somewhat more incremental and deliberate pace. On the retail side, the first major change came with the Garn–St. Germain Act of 1982, which authorized banks and thrifts to offer money market deposit accounts (MMDAs), transaction accounts with no interest rate ceiling, which allowed them to compete directly with MMMFs. Until the end of the 1990s, most of the other changes were facilitated by Federal Reserve Board rulings. The Federal Reserve was given the authority under the 1956 Bank Holding Company Act and the 1970 amendments to the act to determine what activities could be conducted by banking organizations, subject to the condition that these activities be “closely related to banking.” In 1987 the Federal Reserve allowed banks to form investment banking subsidiaries (Section 20 subsidiaries), and in 1989 the Federal Reserve granted limited (percent of bank income) corporate securities underwriting privileges to a select group of banks. The percent-of-bank-income limitations were gradually relaxed during the years that followed.

Some of the most fundamental changes in the banking industry over the past two decades are a direct result of the growth of securitized lending. However, unlike the deregulatory changes just discussed, in which government basically got out of the way, securitization is a story about government intervention right from the beginning. Securitization began in the 1960s with the creation of the Ginnie Mae passthrough and exploded in the 1980s with the development of the collateralized mortgage obligation. Two government-sponsored enterprises (GSEs), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), are dominant forces in the residential mortgage market.2 As of 2003 investors held approximately $2 trillion in mortgage-backed securities issued by Fannie Mae (about $1,300 billion) and Freddie Mac (about $770 billion), and Fannie and Freddie held an additional $1.5 trillion of mortgages and mortgage-backed securities directly in their own portfolios. Together, mortgages securitized by, or held in the portfolios of, these two GSEs accounted for about 47 percent of total residential mortgage debt in the United States.

Securitization combined financial innovation with technological innovation. The financial innovation is the synthetic creation of a liquid, traded security from a pool of illiquid, nontraded assets (for example, individual residential mortgages and credit card receivables) where often the payoff characteristics of the traded securities are altered significantly from those of the underlying assets. For example, securitization has become an important tool for community banks to geographically diversify their otherwise locally concentrated loan portfolios. The technological innovation is the efficient compilation, computation, and dissemination of information related to the performance and operation of the asset pools. One of the key links in this information chain is credit-scoring technology, which transforms quantitative information about individual borrowers (such as income, employment, or payment history) into a single numerical credit score, which lenders can use when screening and approving loan applications, securitizers can use to group loans of similar risk into pools, and investors can use (together with other information) to evaluate the risk of the resulting asset-backed securities.

Comprehensive deregulation, consolidation, and widespread technology adoption

Banking industry deregulation reached its zenith during the 1990s. In 1994 Congress rationalized the patchwork of state-by-state geographic rules by passing the Riegle-Neal Interstate Banking and Branching Efficiency Act, which effectively repealed the McFadden Act at the national level. The immediate response was the highest-ever five-year run of bank mergers in U.S. history in terms of both the number and the value of the banks acquired (Berger, Buch et al. 2004). Although the most prominent mergers and acquisitions are the “megamergers” that combine two large banking companies, the vast majority of U.S. bank mergers since (as well as before) Riegle-Neal have involved at least one community bank. In 1999 Congress, its hand forced by the announced merger of CitiBank (the largest U.S. bank) and Travelers (one of the largest U.S. insurance companies), passed the Graham-Leach-Bliley (GLB) Act. GLB effectively repealed the Glass-Steagall Act and granted broad-based securities and insurance powers to commercial banking companies.

These congressional acts ratified the decades-long deregulation movement, and as such they marked the culmination of story lines that began in the 1970s and 1980s. By removing long-standing limitations on bank size and bank product mix, these acts helped accelerate the adoption of new financial processes and information technologies by U.S. banks. In general, larger banks have been quicker to adopt new technology than have smaller banks, including electronic payments technologies, transactional Web sites, small business credit-scoring models, ATMs and ATM networks, loan securitization, and various off-balancesheet activities. However, the more scalable among these technologies disseminated quite rapidly to smaller banks because of the existence of a highly competitive sector of third-party technology vendors and declining costs of delivering these technologies.

Possibly the biggest impact of technology on the banking system has been on the payment system, where electronic payments technologies and fund transfers are replacing paper-based payments (cash and checks) and paper record keeping. The Check Clearing for the 21st Century Act of 2003 (Check 21) permitted banks to improve the efficiency of check payments. By removing the requirement that banks return physical paper checks from the banks where the checks are deposited to the banks that pay them, Check 21 allowed banks to exploit improvements in information technology. Instead, banks could simply transmit electronic check images, saving substantial transportation and handling expenses and potentially easing the competitive disadvantages of check transactions relative to credit and debit card transactions. The technology-driven switch from paper-based payments to electronic-based payments is reflected in the steep increase in automated clearinghouse (ACH) transactions, such as monthly mortgage payments and direct payroll deposits. ACH volume handled by the Federal Reserve increased at a 14.2 percent annual rate from 1990 to 2000, and this pace has resulted in an 83 percent reduction in the costs of producing these transactions from $0.959 to $0.158 in real 1994 dollars. Technology-driven cost reductions in the processing of checks and cash payments have been more modest.

More recently, Internet banking has changed the landscape of the financial services industry by reducing both the importance of geography and the cost of transactions. In its most extreme form, a relatively small number of banks offer their services exclusively on the Internet. As of July 2002 there were just twenty such Internet-only operations; approximately another dozen Internet-only institutions have failed, been acquired, or voluntarily liquidated; and in addition, several large banks have integrated their Internet-only units into the main bank after poor stand-alone performance.The more widespread Internet banking approach is the “click-and-mortar” model that combines a transactional Internet site with traditional brick-and-mortar offices or ATM networks.

A substantial majority of banks have at least an informational Web site, and close to a majority—and virtually all large banks—now offer transactional Internet sites. Because the basic Internet banking transaction has low variable costs, there are economies of scale associated with this production process and distribution channel. However, this does not preclude small banks from offering this technology, because they can outsource both the development and the maintenance of their Internet sites to website vendors. There is some evidence that offering Internet banking services enhances the profitability of small banks.

Overall, the increased efficiency that results from a shift from paper-based to electronic payments should reduce the amount of transactions balances required by consumers. Indeed, consumers have reduced the fraction of their financial assets allocated to transactions accounts by a third, from 7.3 percent in 1983 to 4.6 percent in 2001 (Federal Reserve Survey of Consumer Finance). Moreover, the increased efficiency that results from a shift from full-service head offices to more specialized delivery channels (branches, ATMs, Web sites) should reduce the number of inputs that banks require to produce a given amount of banking services. The number of offices (bank branches plus the head office) per bank has nearly quadrupled since 1970, while assets per office, deposits per office, and transactions per office have steadily increased, and the number of full-time employees per office has declined.

Re-purposed from "How Banks Work", by Lee Ann Obringer

Economic Importance of Banks

Banks serve a variety of functions in the economy but service the profit motives of shareholders/owners. Acting as a go-between or intermediary between savers and borrowers is probably the most important function of banks. Banks induce people to save their money by offering to pay interest. These savings are then lent to borrowers at an interest rate higher than that paid to savers, allowing the bank to profit. The saver benefits because he earns interest on a safe and relatively liquid financial investment without having to evaluate whether a potential borrower is a good risk. The borrower benefits by having access to a large pool of funds. This is important to the economy because borrowers can now purchase durable goods or invest in capital or housing, which leads to job creation and economic growth.

To understand the economic importance of banks, it helps to look at a bank's balance sheet. A balance sheet compares the assets a bank owns with the liabilities it owes. If you have never taken a course in accounting, then you might not be familiar with the following equation: Assets = Liabilities + Stockholder's Equity. A bank's assets include buildings, equipment, loans to customers, treasury securities, vault cash, and reserves. The liabilities of a bank include customer's deposits and loans from either other banks or the Fed. Stockholder equity, or a bank's financial capital, is the ownership interest in the bank represented by shares of stock. Because assets equal liabilities plus stockholder's equity, changes in a bank's liabilities can create an equal change in a bank's assets. For example, if customers deposit $100,000 in a bank (a liability), then the bank's reserves increase by $100,000 (an asset). On the other hand, if customers withdraw $25,000, then bank reserves are reduced by $25,000 as well.

What exactly are bank reserves? Reserves are funds that are either available for lending or held against checkable deposits. The reserves available for lending are called excess reserves, and those held against checkable (but not savings) deposits are required reserves. Required reserves are held either as cash in the bank's vault or are deposited in the bank's reserve account with the Fed. In the United States, the required reserve ratio, set by the Fed, is the percentage of checkable deposits that a bank cannot lend. For large banks, the required reserve ratio is 10%. Therefore, assuming a 10% required reserve ratio, if customers deposit $100,000 into checking accounts, required reserves increase by $10,000 and excess reserves increase by $90,000. When the economy is healthy, banks tend to lend out all excess reserves. Why? Banks profit by charging interest on loans, so they have a strong incentive to maximize the amount they lend.

Banks Create Money

Contrary to popular belief, most money is not created on government printing presses. When banks accept deposits and make loans, money is created. For example, a $100,000 checking deposit generates an increase in excess reserves of $90,000. If the bank lends the full $90,000 to a customer who in turn purchases a recreational vehicle, the seller of the vehicle might then deposit the $90,000 in the bank. What happened to the checkable deposit balance in the bank? It grew from $100,000 to $190,000 in a short period of time. Money was created. The process does not stop with just this transaction. You can see that the bank now has $90,000 in new deposits. The bank will hold 10% as required reserve and lend the rest. The proceeds of the loan will be redeposited, and now $81,000 of new money is created. This process continues until all excess reserves are loaned out.

Economists are able to estimate the growth in the money supply with the money multiplier, which is one divided by the required reserve ratio. Given that the reserve ratio is 10%, the money multiplier is ten. If $30,000 is deposited into a checking account, economists would predict that the money supply will grow by a maximum of $270,000 ([$30,000 – $3,000] x 10). The accuracy of the money multiplier as a predictor of the money supply is constrained by two factors. The multiplier assumes that banks lend all excess reserves and that the loans are all redeposited. If either of these assumptions does not hold, the multiplier effect is reduced. Many Americans hold on to their cash and that acts as a limit to the money multiplier. Just as easily as money is created, money can also be destroyed. Remember, money is created when customers make deposits and banks make loans. Money is destroyed when customers withdraw balances and pay off loans. Consider the following example. If Maria writes a $10,000 check to pay off her car loan, checkable deposits are reduced by $10,000, and the money supply shrinks.

Banks Make Profits off Interest Payments

Banks work together as a system in bringing together savers and borrowers. They accomplish this by lending and borrowing directly from each other. If a bank is low on reserves and will not fulfill their daily reserve requirement, they are able to borrow from other banks overnight in the fed funds market. For example, assume that Bank X has a customer who withdraws her savings at the end of the business day. Because banks do not hold reserves against savings deposits, this might leave Bank X without the required reserves it must hold against checking deposits. Bank Y, however, may have excess reserves available only earning minimal interest in their reserve account with the Fed. For Bank Y, it is profitable to lend its excess reserves to Bank X at the higher fed funds rate. The fed funds rate is the interest rate targeted by the Fed that banks charge each other for the overnight use of excess reserves.

Sometimes banks may have excess reserves, but businesses or households may not be willing to borrow. Assume that Bank East is holding excess reserves but has no opportunities to lend in its region. Bank West has no excess reserves but has businesses and consumers clamoring for loans. Bank West can borrow from Bank East in the fed funds market and provide loans for its customers. Bank East profits by earning the fed funds rate, and Bank West profits by earning the higher interest rate it charges its customers.

Deregulation Leads to Disaster

A test of the banking system came in the 1980s with the savings and loan crisis. Aggressive lending by the savings and loan industry and lax underwriting led to a series of savings and loan failures. Similar to the FDIC, the Federal Savings and Loan Insurance Corporation (or FSLIC) paid depositors whose institutions had failed. The American taxpayer was ultimately the loser as billions were spent to clean up the financial mess and refund depositors.

Throughout the twentieth century, the American economy grew and industry began to increase in size and importance. Soon, local and regional firms were competing against national firms. American businesses that were national in scope were being served by a banking system that was fragmented and regional. Bank regulation kept American banks relatively small compared to banks in other countries. The banking sector effectively lobbied for deregulation in order to grow and compete at a national and even international level.

The deregulation of banking that occurred in the late twentieth century allowed banks to operate nationwide and also allowed them to expand the level of services they provided. Eventually Glass-Steagall was repealed and banks were engaged once again in the business of speculative investment. As the walls separating traditional banks from banklike institutions came down, the seeds for another financial crisis were sowed. Again the American taxpayer was ultimately the loser as hungreds of billions were spent to clean up another financial mess.

Today, the banking industry is in flux. A push for regulation to prevent future bank crises exists. As the line between banks and other financial institutions has blurred, the task for lawmakers is to create a regulatory framework that encompasses all bank-like activities. The banking system and its players will resist and lobby vigorously in order to keep regulation limit.

Remember, banks serve the interest of their shareholders/owners. Banks provide necessary functions for the economy but exist to make profits. The incentive to drive higher profits, at greater risk, will always necessitate public sector regulation of the private sector banking industry.

A Case for Nationalization

The Barclays interest-rate scandal, HSBC’s openness to money laundering by Mexican drug traffickers, the epic blunders at JPMorgan Chase — at this point, four years after Wall Street wrecked the global economy, does anyone really believe we can regulate the big banks? And if we broke them up, would they really stay broken up?

Many in Washington D.C. — President Obama included — keep hoping the banks can be more tightly controlled but otherwise left as is. That’s the theory behind the two-year-old Dodd-Frank law, which Republicans and Wall Street are still working to eviscerate.

However, when it comes to the really big fish in the economic pond (large complex financial institutions (LCFIs)... too big to fail), the only way to preserve the health of the entire pond is nationalization of the largest ones, which defy regulation.

When it comes to the banking system, bigness and fair play (or even smart policy choices) become mutually exclusive. A few large banks are simply running away with our economic (and political) system. The central problem is that very large banks are able to easily undermine regulatory and antitrust strategies. Large amounts of money and large numbers of lobbyists are used to guarantee regulation is “designed and operated primarily for” the benefit of the banks involved.

With high-paid lobbyists contesting every proposed regulation, it is increasingly clear that big banks can never be effectively controlled as private businesses. If an enterprise (or five of them...the five biggest — JPMorgan Chase, Bank of America, Citigroup, Wells Fargo and Goldman Sachs — dominate the industry, with combined assets amounting to more than half of the nation’s economy.) is so large and so concentrated that competition and regulation are impossible, the most market-friendly step is to nationalize its functions.

What about breaking up the banks, as some economists, politians and corporate leaders suggest? Recent history confirms that while a breakup might work in the short term, the most likely course is what happened with Standard Oil and AT&T, which were broken up, only to essentially recombine a few decades later.

Nationalization solves the toxic asset problem

It has been argued that trying to implement nationalization will be near impossible because we won’t be able to price the hard-to-value “toxic” assets. It is actually the opposite. The current problem is that banks don‘t want to sell the assets at the price the market is willing to pay for them. If we were banks, we wouldn’t want to sell them either. As long as the government is providing free money, why not continue to hold out? Hope is eternal.

But let’s be real. The banks bought illiquid assets with credit risk using borrowed short-term liquid funds. For taking these types of risk, the banks earned a hefty spread. And, in normal times, they raked in the profits. But there is no free lunch in capital markets. In rare bad times, illiquid, defaultable assets are going to be greatly impaired. There is no mulligan here. It will be easier to resolve this within a receivership.

To make the point using a real economy analogy, this past Christmas, Saks Fifth Avenue sold their designer lines at a 70% discount. Designer labels and boutique shops on Madison Avenue were up in arms. How could they sell $500 Manolo Blahnik shoes for $150? In this economy, they are $150 shoes. Moreover, receivership allows one to separate out the assets without having to price them.

Nationalization addresses the moral hazard problem

There is something unseemly about managed funds buying up the debt of financial institutions under the assumption that these firms are “too big to fail”. In theory, these funds should be the ones imposing market discipline on the behavior of financial firms, not pushing them to becoming bigger and more unwieldy.

It has been said by many that this is not the time for thinking about moral hazard. I disagree. If we bailout the creditors, then effectively we have guaranteed the debt of all future financial institutions. We have implicitly socialised our private financial system.

It is certainly true that we can institute future regulatory reform to try to quell the behavior of large complex financial institutions. But this will be complex and difficult to implement against the implicit guarantee of “too big to fail”.

Thus, nationalization resolves the biggest regulatory issue down the road, namely the “too big to fail” problem of banks that are systemically important. In one fell swoop, because the senior unsecured debtholders of a bank will lose when it is nationalized, market discipline comes back to the whole financial sector.

So the large solvent banks will have to change their behavior as well, leading, most likely, to their own privately and more efficiently run spin-offs and deconsolidation. The reform of systemic risk in the financial system may be easier than we think.

How to manage a nationalized bank?

Does the government have the ability to run a large complex financial institution? These institutions have literally tens of thousands of transactions on their books –, who is going to manage a LCFI while it is a government institution, good bank or bad bank? Certainly, no one envisions Barney Frank or Christopher Dodd as the Chief Investment Officers of these firms, but there are many concerns. The government can go and hire professionals as they have done with Fannie Mae, Freddie Mac, and AIG. But much of the value of a Wall Street firm is in its vast array of intangible, human capital. This labor is incentive-driven. How much franchise value will be lost during the nationalization process?

Let’s assume this gets sorted out and the government mirrors employment practices at other firms. But then, with the government’s protection in receivership, what is to prevent the LCFI from making too many, risky loans? They will have a competitive advantage over solvent, albeit less-supported banks. This issue has recently come up with other government-supported institutions. Indeed, the argument has been made that AIG and Northern Rock, to name just two institutions, have undercut their competition by offering overly cheap insurance and mortgages, respectively.

When all is Said and Done

Nationalization isn’t as difficult as it sounds. We tend to forget that we did, in fact, nationalize General Motors in 2009; the government still owns a controlling share of its stock. We also essentially nationalized the American International Group, one of the largest insurance companies in the world, and the government still owns roughly 60 percent of its stock.

Of course, it will probably take another financial meltdown to make banking nationalization politically tenable. But given how the sector has behaved since the last crisis, a repetition seems inevitable, and sooner rather than later. When it comes, we would do well to keep nationalization of the banks in mind when we contemplate how to rebuild a more equitable economy.

Epilogue: Sweden1

Sweden has been cited frequently as a model of “nationalization”. While this is probably an exaggeration, the Swedish approach is in many ways a model in terms of the principles it puts forth to handle a financial crisis. Putting aside the obvious fact that Sweden’s economy is much smaller and its financial institutions much less complex, it is a useful exercise to describe some basic facts.

The distribution of assets within the Swedish and US banking system were similar. For example, while Sweden had 500 or so banks, 90% of the assets were concentrated in just six. In the US, while there are over 7,500 institutions, and the majority of assets are concentrated in the top 15 or so.

Sweden’s credit and real estate boom in the late 1980s closely mirrors the recent US boom prior to the crisis. There was even a similar shadow banking system that developed during these periods – in Sweden, unregulated companies financed their operations via commercial paper; in the US, unregulated special purpose vehicles used asset-backed commercial paper. When the bubbles began to burst, there were also sudden collapses in these markets as a few of these companies and special purpose vehicles began to fail.2 Ultimately, the funding came back to the banks, causing them to have large exposure to the real estate market.

As conditions eroded in 1991, the Swedish government forced banks to writedown their losses and required them to raise more capital or to be restructured by the government. Of the six largest banks, three – Forsta Sparbanken, Nordbanken and Gota Bank – failed the test. One received funding and the other two, Nordbanken and Gota bank, ended up being nationalized.

These latter two banks had their assets separated into good banks and bad banks. The good banks ended up merging a year later and were sold off to the private sector. The poorly performing loans were placed in the bad banks, respectively named Securum and Retrieva. These banks were managed by asset management companies who were hired to divest the assets of these banks in an orderly manner. (It took around four years.)

The main lessons from Sweden for the current crisis are:

1. Decisive action in terms of evaluating the solvency of the financial institutions.
2. Some form of “nationalization” of the insolvent firms.
3. Separation of these insolvent firms into good and bad ones with the idea of reprivatising them.
4. The management of the process was delegated to professionals, as opposed to government regulators.

 

While complexity may affect the application of these principles to the current crisis, it does not nullify them.

Re-purposed from "The case for and against nantionalisation", by Matthew Richardson and "Wall Street Is Too Big to Regulate", by Gar Alperovitz