The regulatory changes undergone by the U.S. banking
system in the fifty years since the founding of FEE are a very close
reflection of the broader intellectual changes that have taken place
during the same period, many of which are due to the effort of people
associated with the Foundation. One can plausibly argue that, in several
respects, the U.S. banking system is less burdened by regulations than
at any time in the past. At the same time, however, the regulations that
do remain hamper the operation of profitable banks, harm consumer
welfare, and continue to undermine the safety and stability of the U.S.
banking system. The grudging removal of some regulations by the federal
and state governments has enabled banks to provide a range of products
and services (both economically and geographically) that was unheard of
just a couple of decades ago. If deregulation of the banking industry
continues into the next century, American consumers will more fully reap
the benefits of freedom in this most central of industries.
The American banking industry of 1946 would seem odd to
someone who has come of age in the 1980s and '90s. Banking institutions
were rigidly divided into commercial banks or savings and loans
associations; neither was able to operate across state lines, and many
states prevented both from operating branches even within the state.
Options for consumers were extremely limited-for most, simply a choice
between a passbook savings account that could earn no more than 5
percent interest, and a checking account that, by law, could earn no
interest. Financial institutions were frequently "mom-and-pop"
operations, with many observing so-called "bankers' hours" of 10 to 3,
and almost all facing relatively little competition from nonbank
providers of financial services. 1 There were no ATMs, no
mutual funds, very few credit cards, just one kind of mortgage, and
virtually no price competition because of price controls on interest
payments. 2
In the intervening decades, the banking industry has
undergone numerous changes, many due to investments in advancing
technology that has made new kinds of financial services available to
consumers. A list of examples would be quite lengthy, but one group
should make the point. The development of high-speed computers and the
associated communications technology have made possible ATM machines,
wire transfers, and a variety of sophisticated financial instruments
that depend on computer calculations to figure the riskiness of
alternative financial assets in a portfolio. The explosion of choices
available to consumers of even modest means is tribute to both the
market's ability to generate technological innovation through
competition (where that freedom is allowed) and the prosperous standard
of living in the United States that has enabled consumers to demand more
sophisticated financial instruments.
The Push for Change
In addition, many of the industry's changes have been
due to genuine deregulation, the push for which has come from three
sources. First, the inflation of the 1970s radically changed the banking
industry by creating problems it had never faced before. Second, the
advances in technology and communications that simplified the moving of
money made the existing geographic restrictions on banking seem even
more archaic than they already were. Third, the general skepticism
toward centralized government solutions that emerged in the 1980s (a
result of historical events both here and abroad and changes in the
intellectual landscape) generated political support for deregulation.
3
The inflation of the 1970s was responsible for a number
of changes in the banking industry, dealing primarily with the price
controls on interest rates. As inflation caused interest rates to rise
as high as 20 percent by 1980, consumers and banks faced serious
problems. For consumers, the problem was finding a place to put money
that could earn rates of interest that would compensate them for the
ongoing inflation. If the inflation rate was 10 percent, then money
deposited in a standard checking account that paid no interest eroded by
10 percent per year. Passbook savings accounts offered only about 5
percent interest and did not allow checks to be written against them.
Neither option was desirable. As a result, consumers wanted to find ways
around the price controls to earn competitive interest rates on their
bank balances.
One option, buying large denomination financial
instruments that were allowed to pay higher rates of return, was
frequently out of the reach of small savers. The brilliant
entrepreneurial solution to this problem during the mid-1970s was the
money market mutual fund. These funds (often operated by nonbank
financial institutions) would pool the savings of their customers and,
in turn, buy large denomination certificates of deposit (over $10,000),
which were not subject to the interest rate controls. After subtracting
administrative costs and profits for itself, a money market fund would
pay its customers slightly less than what it earned from the CDs, but
far more than depositors were receiving from standard checking or
savings accounts. The result was a major drain of funds away from
conventional banks, toward financial institutions that were offering the
new money market instruments.
Of course the banks did not stand idly by while this
was happening. They appealed to regulators to allow them to offer
special kinds of interest-bearing checking accounts akin to the money
market mutual funds. They also lobbied for the removal of the interest
rate controls that dated back to the mid-1930s. Both of these efforts
were successful and now banks can offer a wide range of mutual fund
instruments and are free to pay competitive interest rates on standard
checking accounts. In these ways, banks are notably freer than they were
fifty, or even twenty-five, years ago.
Often overlooked in the popular press was that the
savings and loan failures of the 1980s were rooted in the inflation of
the 1970s. As interest rates rose due to inflation, savings and loans
who had granted thirty-year mortgage loans at low, fixed rates of
interest found themselves in trouble. They were only earning five or six
percent on their loans, but had to pay up to 20 percent to bring in new
funds. This combination was a recipe for disaster, and sent many savings
and loans into a tailspin as early as the middle and late 1970s. In
addition, double-digit inflation also spurred the development of
adjustable-rate mortgages, as well as the whole secondary market in
mortgage-backed securities, as ways for banks to shield themselves
against interest rate risks. In so doing, the banks also offered new
options to consumers who might prefer adjustable rates if they believed
interest rates would fall in the future.
As the troubles of the savings and loans continued on
into the early 1980s, the acquisition of failing institutions by
stronger banks or savings and loans was seen as a way to avoid some of
the most harmful effects of bank failures. However, federal regulations
limited such opportunities by restricting interstate mergers and
acquisitions, particularly for savings and loans. In 1983, Congress
passed the Garn-St Germain Act, which allowed interstate mergers and
acquisitions if the acquired institution was in serious trouble.
Although brought on by previous government activity (i.e., the
inflation), this regulatory change was a step in the right direction,
and opened the door to further activity in interstate banking.
Along with the need to address the devastating effects
of inflation on the banking system, two other factors were crucial to
ending the geographic limitations on banks and savings and loans. As
communications technology continued to change, as domestic and
international markets expanded, and as the population became more
mobile, the limits on interstate banking - cemented in place in the
1920s - became increasingly burdensome. In addition, the high
concentration of bank and savings and loan failures in Texas and
Oklahoma after the fall in oil prices in the 1980s also suggested that
interstate banking was desirable. The oil-state banks had significant
limits on their ability to make loans across state lines. As a result,
they were heavily tied to oil-related firms. When oil prices fell, the
firms collapsed, taking the banks along with them. 4 Both
banks and policy makers recognized that increased opportunities for
geographic diversification were needed.
From about the mid-1970s forward, some states began to
address the interstate banking issue through a loophole in the law. The
Douglas Amendment to the Bank Holding Company Act of 1956 allowed
individual states to admit banks from other states by a specific
legislative act. For example, New York could negotiate an arrangement
with New Jersey to allow each other's banks to cross the state line.
From the mid-1970s onward, states began to make just these sorts of
arrangements, in most cases by forming regional reciprocal agreements.
5In the last five years or so, most states have opened their
borders to any other state that is willing to reciprocate. Moreover, as
of September 1995, national legislation went into effect that allows
banks from all states to merge with or acquire banks in any other state.
These changes in the interstate banking laws are among the most
significant deregulatory moves in the recent history of banking. They
promise to provide heightened competition and greater safety in the
years to come by allowing banks to better diversify their loan
portfolios.
Despite these gains, significant problems still exist
with the regulatory structure of the banking system, three of which I
will briefly discuss. Perhaps the most important is the federal deposit
insurance program. Banks are forced to pay premiums into a fund designed
to pay the depositors of failed banks. Because premiums are based solely
on amounts deposited without regard to portfolio risk, banks are
inclined to worry less about risky lending practices.
One factor contributing to the crisis of savings and
loans was Congress' allowing them to enter the commercial real estate
market in the early 1980s - by itself not a mistake as it allowed
diversification - at the same time it raised the maximum amount covered
by deposit insurance from $40,000 to $100,000, thereby giving the
savings and loans both more ability and more incentive to undertake
risky loans. When the real estate market took a tumble later in the
1980s, many banks and savings and loans were taken down with it.
Industry analysts have pointed out that 43 percent of the total losses
of savings and loans were due to bad real estate investments. Had the
deposit insurance ceiling not been raised (or not existed at all) and
had savings and loans been able to lend across state lines more easily,
the overall riskiness of their loan portfolios would have been lower and
the number of failures would have been far less. Reforming, abolishing,
or privatizing federal deposit insurance remains one of the most
important policy issues facing the banking industry as a new century is
about to begin.
"Attending FEE seminars, reading the literature, and
making great friendships there has meant a remarkable professional life
for me. It was a Henry Hazlitt book from FEE, The Failure of the 'New
Economics, that brought me in touch with the Committee for Monetary
Research & Education, an organization that has be come respected
throughout the nation and abroad.
As FEE, moves into, the next fifty
years, its work is more important than ever and will continue to serve
as a vital foundation for a better society and nation."
Elizabeth B. Currier
President, Committee for
Monetary
Research & Education, Inc.
A second set of regulation still plaguing banks, and,
according to a survey of bankers, the single most costly set of
regulations they face, are those associated with the Community
Reinvestment Act of 1977. This law forces banks to make a certain
percentage of their loans to individuals and businesses in their local
area, and requires an immense amount of paperwork to document their
compliance. Beyond the waste of the paperwork, the CRA increases the
riskiness of banks by forcing them to make loans to borrowers to whom
they would not otherwise lend. The CRA amounts to a wealth
redistribution program with banks as the means. In the end, consumers
and taxpayers carry the burden either because banks are forced to forgo
making other loans (what economists call an opportunity cost) or
government bails out depositors of banks who fail due to too many bad
loans. The CRA seems likely to linger on as onerous as ever despite
efforts by the Congressional majority to weaken or eliminate it.
6 Ending the CRA would both release needed bank resources and
enhance the stability of the U.S. banking system.
The third set of restrictions on banking freedom is a
much more fundamental one. The span of FEE's existence is virtually
identical with the period during which the Federal Reserve has become
the dominant policy-making force in the U.S. economy. It has done so by
being insulated from any political or economic constraints on its
decision-making power. The wide range of discretion given to the Fed to
promote "full employment" reflects the intellectual atmosphere of 1946,
also the year in which the full employment mandate was thrust upon the
Fed. In the fifty years since, the increased skepticism concerning
government in general, and of discretionary monetary policy in
particular, has led many economists to challenge the validity of the
task assigned to the Fed. In 1996, Congress may consider removing the
"full employment" mandate on the Fed, and its concomitant discretionary
power, replacing it with a mandate for price stability. 7
The downside of such a policy change is that the most
important and fundamental power of the Fed, its monopoly over the
production of currency, would remain un-dented. This monopoly is what
ultimately enables the Fed to change the money supply as it deems
appropriate and gives it the power to inflate away the value of the
dollar. Binding the Fed to price stability (while arguably better than
full employment) is still theoretically controversial among free-market
economists and leaves intact the Federal Reserve's power to inflate.
Chal-lenging the Fed's monopoly over the pro-duction of currency and
removing the dol-lar's fiat status will remain important tasks facing
free-market thinkers in the next fifty years.
As we have seen from the changes in the former Soviet
Union and Eastern Europe, the ruling ideas of the mid-1940s are fading
from the scene, being replaced by ideas from scholars who were fortunate
enough to have access to the ideas and resources of orga-nizations like
FEE who kept alive the clas-sical liberal tradition through its darkest
days. The changes that have occurred, and the minor victories that have
been won, are surely not enough, and the power of the old ideas lingers
on in the existing regulations and government power which shackle the
creative energy of the U.S. banking system.
The next fifty years hold great promise for building on
the changes we have already seen and increasing the level of freedom in
the U.S. banking industry.
At the time of the original publication, Dr. Horwitz
was Eggleston Associate Professor of Economics at St. Lawrence
University in Canton, New York and is the author of Monetary
Evolution, Free Banking, and Economic Order, as well as numerous
articles, on financial history and banking regulation.
1. Bankers' hours were not as much of a problem at a
time when most families had only one adult working full-time during the
day. Housewives could do the banking during the daytime hours when banks
were open. It is also true that the limited hours tended to create fines
at banks, especially when drive-up windows and ATMs were not as common
as today, creating additional inefficiencies.
2. Of course banks skirted these controls by offering
non-monetary forms of interest such as free toasters or clock-radios
when you opened a new account. The primary effect of the interest rate
ceilings was to divert resources into less efficient forms of interest -
an important lesson for the ongoing discus-sion of price controls in the
health-care industry.
3. It is worth mentioning that this was not a
Republican Party phenomenon. One of the co-sponsors of the airline
deregulation bill was Ted Kennedy, and one of the co-sponsors of the
recently enacted interstate banking bill was Don Riegle, both Democrats.
4. This is also one response to those who blame the
savings and loan crisis on "deregulation." If that was the case, why
were so many failures concentrated in two states, and states that
severely limited the ability of their banks to diversify? If it was just
"deregulation" we would expect the failures to be more widely
distributed.
5. Some states immediately invited banks from any and
all other states into theirs.
6. The banking bill passed in the House on September
28, 1995, included several deregulatory moves, but did not touch the
CRA. Any moves toward its reform or abolition will probably have to wait
until after the 19% elections.
7. As of October 1995, a bill was pending in Congress
to make such a switch. Whether it will come to the floor and get the
needed votes remains unclear. Another measure of the change in the
intellectual landscape is that a presidential candidate (Steve Forbes)
could publically call for a return to the gold standard without threat
of ridicule.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
May 1996, Vol. 46, No. 5.
Yourname@libertyhaven.com
