Wednesday, October 15, 2008

The US Banking System: Flawed Past, Nationalized Perfect Future?

John Steele Gordon wrote a wonderful little historical piece, entitled "A Short Banking History of the United States," in last Friday's edition of the Wall Street Journal. It's subtitle was, "Why our system is prone to panics."

Among his observations on the post-Civil War financial sector are these,

"Unfortunately state banks did not disappear, but proliferated as never before. By 1920, there were almost 30,000 banks in the U.S., more than the rest of the world put together. Overwhelmingly they were small, "unitary" banks with capital under $1 million. As each of these unitary banks was tied to a local economy, if that economy went south, the bank often failed. As depression began to spread through American agriculture in the 1920s, bank failures averaged over 550 a year. With the Great Depression, a tsunami of bank failures threatened the collapse of the system.

The reorganization of the Federal Reserve and the creation of the Federal Deposit Insurance Corporation hugely reduced the number of bank failures and mostly ended bank runs. But there remained thousands of banks, along with thousands of savings and loan associations, mutual savings banks, and trust companies. While these were all banks, taking deposits and making loans, they were regulated, often at cross purposes, by different authorities. The Comptroller of the Currency, the Federal Reserve, the FDIC, the FSLIC, the SEC, the banking regulators of the states, and numerous other agencies all had jurisdiction over aspects of the American banking system.

The system was stable in the prosperous postwar years, but when inflation took off in the late 1960s, it began to break down. S&Ls, small and local but with disproportionate political influence, should have been forced to merge or liquidate when they could not compete in the new financial environment. Instead Congress made a series of quick fixes that made disaster inevitable.

In the 1990s interstate banking was finally allowed, creating nationwide banks of unprecedented size.

While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence."

Steele makes two very important points about the US banking system that many people fail to grasp.

First, he notes its historically-rooted structure of many small banks, in contrast to the rest of the world.

As recently as last night, I was discussing the evolving current nationalization of the US banking sector with friends at my fitness club. In one conversation, with an erstwhile 20-year Merrill Lynch veteran, I contended that a rapid, near-total consolidation of core US banking functions- deposit-taking, credit card and mortgage lending, trust, transactions processing and DDA accounts- would be the best thing for this nation's long-term financial health and stability.

Why? Because, as my brilliant former boss, and SVP of Corporate Planning & Development at Chase Manhattan Bank, used to explain,

'Few executives are prepared and equipped to run an entire company, let alone the diverse types of businesses which are part and parcel of a money center bank. We (at Chase) are stuck with, for the most part, ex-lending officers and accounting functionaries, promoted beyond their level of expertise.'

He was right, as I explained in this recent post. And this one, from October of last year.

So we see, courtesy of Mr. Steele's concise historical lesson, that the US relied on the existence of thousands of capable, experienced, seasoned bank CEOs to operate our core banking system.

Unfortunately, we haven't even managed to get those qualities in our average money center bank CEO. How in hell would you have expected, in the past, or expect in the future, this situation to radically change?

It won't.

As long as most of our country's banking assets and business volumes are scattered among even hundreds of banks, with private, risk-taking management, our country will be susceptible to the same financial panics as befell us in 1929 and, again, this year.

Simply put, you cannot have a system dependent upon an illusive, nearly non-existent resource: the well-informed, experienced, competent bank CEO. There simply are not sufficient, qualified business people available to staff each of hundreds of US banks. So allowing that many banks to exist is to invite the next financial panic, courtesy of thousands of bad credit and investment decisions on the part of hundreds of inept, boneheaded, mediocre small- and medium-sized bank CEOs.

Far better to so rigorously nationalize core banking via draconian regulation of allowable businesses, lending standards, etc., and government ownership of preferred shares, as to reduce this sector to a barely-disguised government-guaranteed conduit for safekeeping savings and making consumer mortgage and revolver loans.

Steele's second point involves his articulation of a hoped-for future US banking sector that is well-capitalized, with diversified, large money center banks under coherent, apolitical regulation.

I agree with him on all but the diversification issue. Yes, there is the broad range of businesses inherent in a Glass-Steagall era money center bank- deposits, credit cards, mortgages, installment loans, trust, cash management and transaction processing. But not: brokerage, securities underwriting, proprietary trading, corporate financial advisory.

Further, each of the classical Glass-Steagall era bank functions can be largely reduced to automated, pre-determined, quantitative standards with little or no room for subjective judgment.

To achieve a truly safe, well-regulated US core banking system, I believe you need the following:

-Most US banking assets in a few ultra-large financial utilities: Chase, Wells Fargo, BofA, perhaps Citigroup.

-Heavy regulation which removes any and all risk-sourced profits from the core banking sector.

-Federal government guarantee of all core banking businesses, i.e., deposits, credit card balances, mortgage balances, trust accounts. In short, by forcible, draconian regulation of lending and deposit-investment practices, the government will be able to insure all banking activity, because it will all be reduced to ultra-safe, near-riskless levels.

-All financial instruments which are allowed to be traded will be mandated to be done so via regulated exchanges. As such, counterparty risk, collateral and settlement will be explicitly and transparently managed, to reduce risk of ripple-effects from one counterparty's failure.

-Certain financial instruments would be prohibited, such as the securitization of any collection of underlying assets. Exchange-traded assets of all types would obviate the need for such 'asset backed' securities, when any investor could freely shop an exchange to buy credit card or mortgage assets for diversification purposes.

What's left will be the traditional province of private finance companies, investment banks, private equity shops and fund management companies.

Credit-risk expertise, asset management skill and other uniquely-held financial-service-related skills will be freely marketed in the private sector, either with 100% equity capitalization, or leveraged with private capital.

That's a financial sector in which you could place trust. Core banking functions would be safe, heavily-regulated and totally guaranteed by society, i.e., our government. Riskier financial functions would be totally firewalled from core banking and well-capitalized. Trading of financial instruments would be safely confined to exchanges.

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