Dollars and Sense

It's time we invested in rethinking the regulation of banking.


Despite all the talk these days about reducing the cost and uncertainty of government regulation of business, there is surprisingly little serious attention paid to the web of regulations binding our financial institutions—quite possibly the most heavily regulated industry of them all. Few businesses are so tightly reined in as to where, with whom, and at what price they do business.

For years, the standard procedure in economics courses was to define a competitive system in such a way that it could not possibly be achieved. Deviations from the ideal were then labeled "imperfections," which was true by definition. This "imperfect" market was contrasted with the assumed omniscience and incorruptibility of the public sector. Wherever one could find a plausible flaw in the workings of private markets, a simple leap of faith led many to assume that government regulation was sure to fix it. After all, we were told, people in the private sector are motivated by private greed, while those in the public sector have only the public's interest in mind.

In regulating financial institutions, however, even the usual rationale for regulation is difficult to apply with conviction. There is indeed some lack of competition within formal channels, but it is entirely the product of the regulatory process itself—laws governing the establishment of bank branches and controlling interest rates, for example. These can scarcely be used as an argument for more regulation. "Imperfections" in financial markets are either directly caused by regulation or are an inevitable consequence of the absence of perfect knowledge and foresight—a condition that even afflicts regulators.

A more cynical (and therefore more realistic) explanation for regulation in this area is probably most relevant. This theory suggests that political officials offer regulations in an effort to gain political support. Any regulation, after all, benefits somebody and, in effect, taxes somebody else. There are only two legal ways for an individual or group to acquire more goods and services: either more must be produced and traded, or the political process must be used to acquire goods and services produced by others. An outright tax-and-subsidy scheme, however, would usually be too obvious a way for politicians to buy the votes of those being subsidized; they might lose the votes of those being taxed. The benefits of regulation, in contrast, can be quietly conferred on various organized groups while the costs are quietly dispersed among a large group that has little motive to find out what is going on.

Regulation of financial institutions, for example, has been artfully crafted to aid mortgage borrowers at the expense of less-affluent small savers or to aid certain other classes of borrowers at the expense of the financial institution's depositors and stockholders. But it doesn't work. Money flows too easily around regulatory barriers. People can and do figure out ways to circumvent such barriers faster than regulators can dream up new ones.

What regulation does manage to do is simply to lessen the ability of the most tightly regulated financial institutions to compete with a growing number of less-regulated alternatives—commercial paper, money market funds, and credit unions, for example. If we continue to burden financial institutions with regulatory costs and risks, borrowers and lenders will get together outside such formal channels, using relatively inefficient alternatives. Financial instruments and institutions will be selected on the basis of their exemption from the regulatory tax, rather than on quality and underlying cost.

In the early 1930s, the federal government raised tax rates and tariffs, pushed unionization to raise wage rates, and let the banking system collapse. The resulting depression was, of course, blamed on the private, competitive economy. So we had a flurry of regulatory activity to restrain competition and foster cartels.

In lending, laws were passed carving up pieces of the business by area and function. Limited franchises were given to banks, thrifts, and securities firms, with protective walls built between them. Other laws set interest rates on deposits, because it was felt that bankers, if left to their own devices, would give away all their profits to consumers.

The regulatory structure for commercial banks consists of geographic limitations on deposit gathering, or branching (the McFadden Act, state laws, the Banking Act of 1933, and the 1956 Bank Holding Company Act), price controls on interest rates paid to consumers (Regulation Q), investment banking restrictions (Glass-Steagall), and prohibition of payment of interest on demand deposits (Banking Act of 1933). Banks are regulated by the Federal Reserve, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and state regulators.

Time is now tearing down all the old walls, however, and competitive market forces are prevailing. Eyes opened when the largest insurance company, Prudential, acquired the eighth largest broker, Bache. They opened wider when American Express acquired Shearson. But these were just small parts of an ongoing evolution that began years ago.

The auto companies have huge financial arms. GE credit is big in term loans. Sears has a bank, an S&L, a gigantic insurance company, and 22 million credit cards. RCA owns a finance company. Bechtel owns Dillon Read. Merrill Lynch is big in real estate, mortgages, relocation, and everything else. The Merrill Lynch Cash Management Account not only pays market rates on demand deposits but tosses in a Visa card, cash advances, and overdraft privileges. Merrill Lynch, however, is not a bank. Banks can't engage in finance or commerce, but financial and commercial firms can and do engage in banking.

In a state, such as Illinois, with no branching at all, except for tax-exempt credit unions and federal S&Ls, the increasing absurdity of geographic restraints becomes obvious. Research by Larry Mote of the Chicago Federal Reserve Bank indicates that branching provides lower interest rates on loans, higher rates on deposits, more consumer lending, and great mobility of funds from surplus to deficit areas. Where branching is allowed, the larger, more-diversified banks are also safer. That is, competition works. It would work for banks operating across state borders, too.

The reality of the financial world makes geographic limitations unenforceable, anyway. Domestic banks are not allowed to operate out of state, but Morgan Guaranty and Chase have moved into Delaware, and Citibank set up credit card operations in South Dakota (to escape usury laws). All major banks have Edge Act branches for international business, and the Fed is moving to include domestic business of some international firms.

When I deposit money in my New York money market fund, its managers buy large certificates of deposit (CDs) from banks in Chicago, so a New Jersey resident is really depositing funds in Chicago. With an American Express "gold card," funds can be withdrawn from a participating bank anywhere in the nation.

Limits on branching also take their competitive toll. If financial service companies are ranked by their 1979 income, only 2 banks appear in the top 10—Bank of America ranks fifth, behind the biggest insurance companies; Citicorp, seventh. Other slots are filled by Sears and American Express.

In 1972, four US banks were in the top 10 worldwide; by 1979, there were only three within the top 12. There are over 100 foreign banks in this country, with assets well above $100 billion. One operates 100 branches in six states. Foreign banks capture about a third of the business loans in New York and California. They can acquire US banks when other US banks cannot.

Just as foreign banks and electronic terminals are straining the credibility of geographical limitations on deposit gathering, money market funds are straining the credibility of legal limits on the interest paid on deposits. True, the Monetary Control Act of 1980 does require that passbook rates be raised to 6 percent by mid-1983, but that doesn't worry the money funds too much.

Requiring regulated institutions to hold reserves that pay no interest is a very heavy tax when interest rates are high. It raises the cost of deposits, making loans more costly and less competitive with unlicensed alternatives like commercial paper. Ingenuity helps here, too, but not enough. Reservable deposits can disappear overnight into Caribbean Eurodollars or repurchase agreements, becoming just as spendable the next day as money. Money funds can convert large CDs into checking accounts, circumventing the steep reserve tax on demand deposits. Slap reserve requirements on these innovations, and others will appear the next day.

A money market fund may buy a bank's $100,000 CD, carve it into a hundred $1,000 units, and charge a fee for doing so. If it were not illegal, strong banks would gladly provide that service with a higher return, simply by eliminating the middleman.

Although economists speak fondly of competition as an alternative to regulation, financial institutions are getting more of both—more competition and more regulation. Since 1974, there have been at least eight major new laws regulating banks and thrifts, usually with words like truth, fairness, and equality in their titles. If Congress faced any standards of truth in labeling and open disclosure, these laws would have to be renamed. In practice, very few government regulations of financial institutions make any economic sense whatsoever.

But the useless nuisance of existing regulation pales before the threat that unelected regulatory officials may increasingly be empowered to dictate who shall receive credit on what terms. The political power implicit in such bills as the Credit Control Act of 1969 is truly awesome, and the Community Reinvestment Act of a decade later has the potential to be abused for similar purposes.

Whenever something is scarce and desirable, including credit, there must be one of three rationing devices to decide who gets what. The only alternatives to the price system are rationing by political preference or the queue ("first come, first served"). The price system allocates resources toward uses that consumers value most highly. A price system, for example, will channel credit toward uses that are expected to yield sufficient return or satisfaction to justify the interest expense.

Political preference, on the other hand, allocates resources to those with the most political clout—organized interest groups that can mobilize votes and campaign contributions, or those willing and able to offer less-subtle bribes. Needless to say, the poor and uninfluential do not fare well in any scheme built on political influence and priorities. Their purpose is, instead, to serve as a rhetorical device to disguise what is really going on. A political system for allocating credit carries great promise as a vehicle for fostering graft, corruption, and wasted resources—and reelection.

The federal government is, of course, already deeply involved in channeling credit to politically favored uses through such huge and mysterious conduits as Fannie Mae and the Federal Financing Bank. Much of the federally supported or guaranteed debt could charitably be described as unsound, such as advances to bankrupt developers from the now-terminated New Communities Administration, many housing and student loans, the guarantee of New York City securities, and backing of US bank loans to Eastern European governments. Uncle Sam's own record as a lender should not give anyone confidence in the government's capacity to recognize safe and sound banking practices.

The many federal agencies that supposedly provide funds to the mortgage market have no lasting net effect. People simply buy agency securities instead of depositing their money in mortgage-lending institutions; insurance companies and commercial banks likewise hold more agency debt and fewer mortgages.

The government's efforts to divert credit flows to low-income urban housing and minority-owned small business have been very expensive, plagued by scandals and defaults, and remarkably unsuccessful. With taxpayers understandably upset by such uses of their money, in recent years we've seen an attempt to do good deeds with other people's money—namely, with the money that stockholders and depositors have entrusted to banks and thrifts. Regulatory threats and harassment seem ideally suited to such political redistributions of wealth, and they avoid the cumbersome process of subjecting the wealth transfers to close public scrutiny and voter approval.

The Community Reinvestment Act leans toward special favoritism for dwellings and whole neighborhoods, rather than simply requiring the absence of unfair treatment based on irrelevant individual characteristics. The initial benefits from the supposed added provision of mortgage credit would flow to those who could thereby sell their houses at a higher price, quite possibly producing white flight at the expense of those buying the houses and at the expense of poorer people facing a smaller stock of what might otherwise be rental housing. There is, in short, a redistribution of wealth involved that may be quite different from what some would like us to believe.

To put it bluntly, the Community Reinvestment Act can only be viewed as an effort to push financial institutions into foisting more dubious loans on those who can least afford them. One might suppose that banks and thrifts already have enough bad loans and that consumers have more than enough debt. But the Wisconsin school of populism personified by Sen. William Proxmire loves credit and deplores debt, which is one way of ignoring the problem. When runaway expansion of money and credit produces inflation, some members of Congress just figure that people must need a lot more money and credit to pay those soaring prices.

Regulated financial institutions form an island in an expanding sea of unregulated alternatives. Bankers who fight for the status quo are standing still, which just lets the others move ahead that much faster. Regulatory barriers are being repealed by reality—but it is a slow and distorting process.

A minimal reform is to greatly accelerate the faltering abolition of Regulation Q ceilings on interest rates and to repeal the Douglas Amendment to the 1956 Bank Holding Company Act, facilitating the merger of banks and S&Ls across state lines, at least in four or five broad regions. Reciprocal banking agreements between states would help, too.

The new financial technology will require significant long-term commitments of capital. Such investments will simply not be forthcoming in adequate amounts if a large element of regulatory risk is added to the already formidable uncertainties of monetary policy.

Distinctions between depository institutions will disappear, and distinctions between other financial institutions will be further blurred. Finance will become more efficient and competitive, with explicit full-cost pricing of services.

Whether regulatory reform plays a lagging or a leading role, competitive and technological forces will initiate the change.

Back in the 1830s, Congress seriously contemplated shutting down the US Patent Office on the grounds that everything had already been invented. We now have the hindsight to say they lacked foresight. But technology always develops differently from the way we suppose it will. Today, we don't even know what will be considered valuable natural resources in the future, any more than our grandparents knew what we would do with uranium. One thing we do know is that man's ingenuity is awesome and that scientific progress is accelerating at a rapid pace as one invention leads to many uses that are, in turn, multiplied many times again.

We also know, from history and experience, that attempts to delay the sometimes frightening onrush of technology only succeed in diverting new techniques to other areas, leaving obsolescence as the price of obstruction. We must never forget that we operate in a highly competitive global marketplace and that capital, labor, and money can and do move to places that are most conducive to doing business. If some states or nations promote more-efficient methods of providing financial services, then their financial sectors, and the activities they finance, will come out ahead in the competition for capital.

The power of the marketplace can and will undermine financial regulations. The process would be far more orderly and efficient if the regulations were simply discarded.

Contributing Editor Alan Reynolds is vice-president of Polyconomics, Inc.

Saving the S&Ls

Ii is emerging as a major policy battle of the immediate future: how to save the failing savings and loan associations. The sides are now taking shape—those who would deregulate the industry versus those calling for multi-billion-dollar bailout plans.

Just how bad off are the S&Ls? In a policy paper released in February by the Washington-based Cato Institute, analyst Joe Stilwell writes that the "most optimistic figures suggest that at least a $100 billion difference exists between the balance sheet figures and the market value of the associations' assets." With an official net worth of $26.7 billion, then, "the S&L industry," Stilwell calculates, "has a negative net worth of roughly $70 billion."

Other indicators also show a seriously declining pulse. In 1981 the S&L.s suffered record withdrawals of nearly $6 billion. Instead of selling off assets to maintain liquidity, the associations resorted to massive borrowing of below-market-rate money from the Federal Home Loan Bank (FHLB) system, to which the industry now owes about $57 billion. Such loans are increasing monthly. Mergers within the industry are occurring in rapidly growing numbers, too. The FHLB board—a federal overseer of the S&Ls—has classified almost 400 S&Ls as having "substantial difficulties." "Regardless of changes in the economic climate"—that is, whether interest rates rise, fall, or remain at present levels—"numerous S&Ls," Stilwell predicts, "will be unable to meet their financial obligations." Indeed, according to FHLB board chairman Richard Pratt, if interest rates remain at current levels, one S&L will be reduced to zero net worth every business day.

Ostensibly, the S&Ls' problem is that their earnings from older, low-interest mortgages cannot cover the high rates they must offer to attract new deposits. Fierce competition for those deposits comes from institutions able to offer unregulated interest rates. So great are the S&Ls' losses that in February Rep. Fernand St. Germain, a Democrat from Rhode Island, introduced a $7.5-billion bailout bill for the industry. In addition, two industry trade groups—the US League of Savings Associations and the National Savings & Loan League—have both proposed government-aid plans, the latter group calling for a $15-billion bailout.

But these "patching up" programs, which, according to Stilwell, ignore the root problem plaguing the S&Ls—continuation of a long history of government involvement in and regulation of the industry—"can only put off the fundamental problems. And the unrealized losses will grow larger during the patching process." Government restrictions on S&L activities hamper the associations' ability to respond quickly and freely to market forces, and government solutions—subsidized loans, for example—perpetuate poor market adaptation. Deregulation, says Stilwell, is the only effective medicine for what he calls "an ailing giant teetering on the brink of collapse."

Several deregulation plans have appeared of late. Last October, Republican Sen. Jake Garn of Utah introduced a bill to allow the S&Ls to expand their activities and become more competitive in the financial-services market. In February, the FHLB board also proposed to widen S&L activities to permit the beleaguered associations to grant corporate loans and checking accounts, sell money-market funds and insurance, and act as real-estate agents in the buying and selling of homes.

In addition to these deregulatory proposals, the Wall Street Journal in a series of editorials has recently articulated its position in favor of broadly deregulating the entire financial-services market, including the "severely squeezed" S&Ls. The Journal warns that "without heavy-duty pruning, we put important institutions at risk and forgo the advantages of competition."

The S&Ls have largely welcomed proposals for deregulation, though there is concern among them about the failures that would inevitably follow from freeing the market. The concerns are not unfounded. "Deregulation," writes Stilwell, "will result in many losses to investors as decades of financial misallocations are liquidated, but deregulating will also eliminate the underlying problems."

—Eric Marti