During the era of financial deregulation running from 1980 to the financial crisis of 2008 the financial industry morphed so much that there were some who argued that banks were essentially little different from other types of financial institutions such as securities firms and insurance companies. Each of these industries and others within the same universe offered products and services that competed directly with one another. Banks were able to develop funding sources that complemented and in some cases replaced their traditional source of funds, namely insured deposits. Banks, it seemed, were no longer “special,” as leading banker and bank regulator E. Gerald Corrigan had once so eloquently demonstrated (on which, see further below).
The strong current of deregulation encouraged the mindset that banks are really just like other financial and even commercial enterprises. This had at least two consequences. First, it became harder to understand why banks would ever have to be bailed out in times of crisis. After all, such special treatment is seldom extended to other industries–at least not without great political disagreement. Second, the view emboldened bank executives in their belief that regulation was largely an unnecessary intrusion into the functioning of the market. It was assumed and advocated that ordinary market forces ought to apply to banks in the same way as to other forms of business. The resulting political mood is distaste for any kind of emergency action by federal banking regulators to save a failing financial institution.
This kind of thinking has distorted the debate on financial reform because it is fundamentally mistaken. Banks are still special. Like all significant financial institutions they are different from other kinds of enterprise because the financial system is different from commerce. But even more important and unlike other financial institutions they are unique in various ways, and this special status changes significantly the dynamics of their regulation as well as their status in the markets. There are three reasons: (1) banks continue to play a special role in the economy; (2) their inherent interconnectedness creates and cannot ever eliminate systemic risk; and (3) banks are, long have been, and likely always will be “government supported enterprises” (not government sponsored enterprises like Fannie Mae and Freddy Mac).
The first point is one developed by E. Gerald Corrigan in the 1982 annual report of the Federal Reserve Bank of Minneapolis. Mr. Corrigan observed that banks provide a unique combination of functions in the economy: they issue highly liquid transaction accounts (checking and other payment mechanisms); they are backup sources of liquidity for all other institutions, including other banks and through the Federal Reserve System; and they are the transmission belt of monetary policy. These are complicated concepts that would require much greater elaboration elsewhere, but for the moment I would assert that, notwithstanding all the changes in the industry, this assessment remains valid. Mr. Corrigan defended his position, successfully in my opinion, 18 years later after his initial assessment had been called into question because of all the deregulation taking place.
The second point–interconnectedness leading quickly to systemic risk–is illustrated by the example everyone can now recognize, namely the collapse of Lehman Brothers on September 14, 2008. Lehman was an investment bank, not a commercial bank, yet when it failed the world’s lending markets instantly froze and we were plunged into what David Wessel has called the “Great Panic.” Banks, whose interconnected lending is enormously extensive and has to be if the modern financial system is going to be efficient, were not going to keep lending to each other when they did not know the extent of each other’s exposure to Lehman’s failure. This is the essence of a systemic failure. But do not assume that it takes a great failure like Lehman to generate dangerous consequences for the financial system: just today the Financial Times carries a story about a small, seemingly insignificant bank in Córdoba, Spain, whose seizure by the Spanish regulators even weakened the Euro for a moment. The fact is that even smaller banks are deeply interconnected within the domestic and, in most cases, international financial system, and their weakness or, worse, failure, can threaten us all.
The third reason banks are special, and perhaps the most important of all for public policy purposes, is that they are supported in various ways by the government and, in turn, by the public. This support is far more extensive than is the case beyond the financial system. The support comes from the government maintenance of federal deposit insurance, the federal reserve system, the very fact that they are regulated for safety and soundness, and a too big to fail policy that is impossible to eradicate without breaking banks down into much smaller sizes. Do not be misled by the fact that banks pay for deposit insurance through premiums. The reality is that the full faith and credit of the United States stands behind the insurance funds, no matter what is protested publicly, and the FDIC logo is a powerful brand for attracting low cost deposits from the public because we know we will get our money back even if the bank fails. In some years banks have not even had to pay premiums for this insurance system. Banks also fund the activities of the Federal Reserve System, but without the elaborate mechanisms created by the regional reserve banks and the Board and regulatory bureaucracy in Washington the payments system and the backup liquidity provided to banks (and even other financial institutions) on a continuous basis would not exist. For these very reasons banks are regulated to ensure that they do not take unsafe actions (of course this has not worked so well recently, but the system actually does work quite well in more stable times).
The last element–public subsidization–is perhaps the most ignored yet important one of all and has been vividly illustrated by the rating agencies, who have indicated that they will continue to accord higher credit ratings to very big banks because, in their (correct) assessment, such banks will still be bailed out when push comes to shove. In other words, the credit rating agencies have concluded that the new reform legislation will not end the public subsidy known as too-big-to-fail (TBTF). This means that these banks will continue to have access to less expensive funding than they would otherwise have if they were going to be treated as ordinary commercial entities that face bankruptcy when they get into trouble. And this subsidization not only takes various forms, including through programs such as the Troubled Asset Relief Program (TARP) where taxpayers remain on the hook notwithstanding some recent repayments, but it is also extensive, running into $billions per year.
So what are the consequences for public policy and legal accountability? There are too many to delve into here, but two leap out. First, those bankers who assert that regulators should get out of the way–and amazingly there appear still to be some–are conveniently overlooking the facts that their businesses depend vitally on the government and that without public backup they would not enjoy the kinds of profits (and personal compensation) the financial industry generates, even now. Secondly, the legal obligations of directors and CEOs to their shareholders are more complicated than is the case with other kinds of business because the shareholders are not the only stakeholders. This is true even when the Treasury does not own equity or debt in troubled institutions (as it does in some cases); it is true in general. Banks are a different kind of “GSE”–government supported enterprises–and because of this banks will always end up having to be treated as special in various ways.