Free the Banks—Or Else

Several years of fiscal sleight of hand were demolished late in May, when Citicorp shocked the banking world by setting aside an extra $3 billion to cover potential losses on foreign loans. It is no longer possible for U.S. banks to go on pretending that massive loans to Third World countries will ever be repaid at 100 cents on the dollar.

Indeed, after watching Citicorp's stock rise in the week following its dramatic announcement, several large banks quickly followed suit, even though writing down loans means record short-term losses. Competitive pressures may now force much weaker institutions such as BankAmerica to take the same step—raising the specter of a new round of bank failures.

Even before these recent changes, bank failures had reached record post-Depression levels. Nearly 20 percent of all banks insured by the Federal Deposit Insurance Corp. operated in the red last year. So the risk of another major bank failure, such as Continental Illinois's near-bankruptcy—and federal bailout—in 1984, is very real.

Now a politician's first reaction to a riskier climate is to slap on controls in an attempt to forestall bad things. Yet if we are to avoid a banking bloodbath, that's precisely the opposite of what is needed at this point. Ill-conceived banking regulations got us into this mess, and only rapid deregulation can get us out of it smoothly.

American banks are in such dire straits today because they failed to diversify their risks. Major money-center banks overextended themselves in risky Third World loans, while smaller banks in the Midwest and the Southwest grabbed up farm loans and oil loans. Bankers aren't stupid—but more-sensible options were closed off to them…by regulations.

Banks' bread and butter used to be making loans to businesses. But as other institutions have sold businesses on the advantages of commercial paper and junk bonds, the banks have lost about half of their business-loan market. Meanwhile, a huge financial-services industry has been evolving. Players as diverse as Sears, Ford, and Merrill Lynch now compete for banks' customers in areas forbidden to banks by federal regulations—insurance, mutual funds, and securities underwriting. And foreign banks, subject to fewer restrictions, have made major inroads in the domestic market. One of the few growth areas left for U.S. banks was Third World lending.

At the same time, geographical diversification within the United States has been frustrated by a patchwork of laws that limit branch banking. In Illinois, a prohibition on statewide branching prevented Continental Illinois from building up the kind of solid retail network that is one of Citicorp's strengths. So its parent company looked far afield for energy loans—and got wiped out. Similarly, the McFadden Act prevents interstate branching, so banks in a farm state like Iowa or an oil state like Texas are extremely vulnerable to downturns in those businesses.

Banks in Europe and Japan are not hobbled by these and other U.S. controls and restrictions. They can take equity positions in businesses, for example; there is no artificial separation between commercial and investment banking. Nor are they saddled with restrictions on branching in their home countries. Even in this country, they are generally allowed to operate with greater freedom than domestic banks. Consequently, it should come as no surprise that today nine of the world's top ten banks are Japanese. Ten years ago, BankAmerica and Citicorp were at the head of the pack.

Even without the current writing-down of foreign loans, the threats to U.S. bank solvency would be very real. Banks are losing market share at home to new financial supermarkets and abroad to less-regulated Japanese and European banks. But now that Citicorp has called the industry's bluff on accounting for foreign loans, the need for reform is all the more urgent.

Banks must now be given the freedom to compete, across the board, so that they can diversify and spread their risks. That means the 1933 Glass-Steagall Act (which put a wall between commercial and investment banking) has to go. So must the anachronistic 1927 McFadden Act that limits banks to their home states.

Meaningful deregulation has been stalled because of special pleading from small-town bankers, insurance firms, securities dealers, and investment bankers. All are desperate to retain their present protection from real competition.

Their pleas must be ignored. These businesses have no right to be exempted from the laws of the marketplace. There is ample evidence (for example, from New York State) that well-run small banks can compete with large ones. Nor is there any reason why Prudential and Chase Manhattan, along with Sears, shouldn't be free to compete all-out in selling insurance and other financial services.

But Congress should also face the sobering fact that the money is simply not available to handle another major debacle. In thinking about deregulation versus the status quo, Congress should contemplate the possibility of the simultaneous bankruptcy of BankAmerica and Manufacturers Hanover, for example.

Phony-baloney accounting of shaky loans can no longer hide the precarious condition of a number of banks. Freeing our banks to compete and diversify their risks has become a matter of utmost necessity.