Return From the Dead: The Banking Industry Flies High
Fifty billion dollars. Who would have thought that bank profits would reach this record height in 1996? Just six years earlier, experts were dismissing banks as financial dinosaurs unable to compete with the mutual funds, investment firms, and finance companies that were stealing their best customers. As late as 1993, the Wall Street Journal featured a former head of the Federal Deposit Insurance Corporation (FDIC) saying that "The banking industry is becoming irrelevant economically, and it's almost irrelevant politically."There appeared to be good reason for the pessimism. The two main measures of bank profitability had both been trending downward for a decade. Households were increasingly investing their savings in pension funds or mutual funds rather than depositing them in banks. Borrowers ranging from home buyers to major corporations were finding that they could get cheaper loans elsewhere.Even worse, many borrowers were not repaying their loans. The result was that banks were collapsing at an epidemic rate -- more than 1,100 failed between 1985 and 1991. Most ominously, by the end of 1991 the FDIC itself had become insolvent. Taxpayers were threatened by the prospect of a clean-up bill even higher than that for the $200 billion savings and loan debacle that was still fresh in their memories.The current mood could hardly be more different. As bank profits have soared to record levels in each of the last four years, pessimism has been replaced by an optimism bordering on euphoria. At almost exactly the same time last December that Federal Reserve Chairman Alan Greenspan expressed his concern about the "irrational exuberance" of the stock market, the Wall Street Journal noted that the prices of bank stocks had been "rising twice as fast as the overall market for more than two years." Investors' mood swings may be excessive, but the recovery of the banking industry is real.Perhaps surprisingly, the banks' return to health is good news for lower-income people and those involved in small businesses. Large corporations, the wealthy, and the middle class all have alternative ways of obtaining the credit and services that banks provide. But for those in small companies or with lower incomes -- whether located in inner-city neighborhoods, small towns, or rural areas -- there often is no good alternative. Healthy banks mean that more small firms are able to get the credit they need, and that fewer low-income people are forced into the clutches of check-cashers, pawnshops, rent-to-own stores, sub-prime lenders, and other elements of the exploitative, high-cost world of fringe banking.Yet the news is not all good. Banks' dramatic diersification into new lines of financial business has created the current prosperity. But this transformation raises threats to the future well-being of the banks themselves, the overall economy, and the rest of us. Threats to the stability of the banking system are greater than at any time since the Great Depression. Mergers are giving large banks greater abilities to wield economic and political power, with consequences such as higher fees for consumers, especially those with low incomes. And banks whose operations spread across the nation will be far less responsive to the needs of local communities, including residential and small-business borrowers.Reversal of FortuneAs the decade opened, the most threatening aspect of the banking crisis was the rash of bank failures. In each of the last three years of the 1980s more than 200 banks failed, and the annual number remained in triple digits through 1992. These were shocking numbers for an industry where failures averaged less than four per year -- and never reached even double digits in any single year -- during the three decades between the end of World War II and the middle of the 1970s. Just a few years later, however, the number of bank failures has returned to single digits. Only six banks failed in 1995, and the same number last year.The main reason that banks were failing at such a high rate was that bankers had made massive numbers of loans to finance real estate speculation during the late 1980s. When the real estate boom collapsed, many of those who had borrowed the money were unable to repay their loans, and banks found themselves the not-so-proud owners of downtown office towers, suburban malls, and luxury condominium developments that were worth only a fraction of the amount they had loaned. In hundreds of cases, the losses from these bad loans were big enough to force the banks into failure.By the beginning of the 1990s banks had stopped making such ill-advised loans, but they could do nothing to stop the accumulating losses from the loans they had previously made. As real estate prices continued to collapse during the recession of the early 1990s, there was no end in sight to the epidemic of bank failures.At this point, the Federal Reserve Board -- whose primary concern is protecting the health of the banking system -- decided to take dramatic action. During 1991, the Fed cut the key interest rate directly under its control (the so-called "discount rate") on four separate occasions -- from 6.5 percent at the beginning of the year to just 3.5 percent by the year's end. Other interest rates dropped accordingly, the lower rates jump-started the stalled economy, and the number of borrowers who were unable to repay their bank loans dropped substantially. Thanks to the Fed, the banks were on the road to recovery.In fact, virtually all of the increase in bank profits from the depths of 1991 to the heights of 1995 can be accounted for by the drop in bad loans written off by the banks. These fell from $55 billion to $12 billion, thereby raising after-tax profits by $29 billion (assuming an average corporate tax rate of 33 percent). The actual rise in the industry's profits during this period was an almost identical $30 billion, from $18 billion in 1991 to $48 billion in 1995.But stopping the avalanche of loan losses dealt only with the immediate crisis that the banks faced at the start of the 1990s. There was als a long-run problem. Since 1979, a decade before speculative real estate loans caused massive losses, banks' share of the economy's total financial assets had been falling as other kinds of financial firms took away their most profitable customers. In order to survive and prosper in a changed environment, the banking industry needed to transform itself. Accomplishing this was complicated by the outmoded regulatory system, established almost sixty years before, within which banks had to operate.The Post-Depression Regulatory StructureDuring the Great Depression more than 9,000 banks failed -- almost 40 percent of the country's total. As a result, the federal government, led by President Franklin D. Roosevelt, established a new system of rules for banking that was designed to prevent such a disaster from recurring.Central to the new system was deposit insurance, guaranteeing that depositors would get their money back even if their bank failed. By promoting depositor confidence, insurance eliminated the bank runs that had brought down thousands of otherwise healthy banks. The three other key features of the new regulatory structure were designed to protect banks from the destabilizing effects of competition.First, the kinds of accounts that banks could offer were restricted, and the maximum rate of interest that banks could pay their depositors was strictly limited. For example, no interest at all could be paid on checking accounts. Second, the law separated the financial industry into distinct compartments, with each type specializing in one or more products and protected from competition with the others. Banks offered checking accounts and business loans, S&Ls specialized in savings accounts and home mortgages, investment banks helped corporations raise money by issuing stocks and bonds, and insurance companies sold insurance. Third, individual banks were allowed to operate only in limited geographic areas.Under this system, which made banking one of the most heavily regulated of all industries, the banking industry flourished for the first three decades following World War II. Bank profits were steady, even if not spectacular. And the banking system provided the financing necessary to fuel the "golden age" of U.S. capitalism. But eventually technological developments and economic changes created problems for the banks.One major change was the surge in interest rates in the early 1970s. By 1974, the interest rate on U.S. Treasury bills (which cost $10,000 each) rose to over 8 percent, well above the 5 percent maximum that banks were allowed to pay their depositors.Accordingly, money began to flow out of the banks and into T-bills and other high-interest investments. The flow became a flood when investment companies like Fidelity and Merrill Lynch began to offer money market mutual funds. This new product pooled together the money of many small investors, thereby making it easy for the non-wealthy to share in the high "money market" interest rates. Starting from nothing in the mid-1970s, the money in these funds grew to over $220 billion in the early 1980s.For banks to hold on to a substantial share of the savings of U.S. households, the first key element of the regulatory system had to be abandoned. Accordingly, Congress in the early 1980s removed restrictions on the interest rates that banks could pay to their depositors.Soon afterwards the geographic limits on banks crumbled. One tactic that banks used to get around the law limiting individual banks to a single state was to create "bank holding companies." These entities collected a number of legally separate banks, in different states, under one corporate parent.Then in 1994 the Riegle-Neal Interstate Banking and Branching Act removed the ability of states to prevent such holding companies from buying banks within their borders, and allowed the holding companies to merge all their subsidiaries into a single bank. When this law is fully phased in by mid-1997, geographic limits on banks will be virtually extinct. The confinement of bank activities to taking in deposits and making business loans has also been substantially eroded, although this aspect of deregulation is not yet complete. Banks have mounted major counter-offensives against the insurance companies, brokerage firms, and mutual funds that had been stealing their customers. Most large banks now offer their customers insurance policies, mutual funds, and investment services in addition to consumer, real estate, and business loans.Although the contending groups are still struggling over the details of pending legislation, it seems certain that banks will soon offer the entire range of financial services. This will mark the final step in the demolition of the regulatory system that defined the banking system for the first quarter-century after World War II.Banking TodayMaking use of the flexibility provided by a dismantled regulatory structure, banks have responded to the rapid changes in technology and economics in ways that have changed banking almost beyond recognition, including:Multi-state operations Since the barriers that restricted banks to operating in a single state began to fall in the mid-1980s, many banks have spread their operations over large areas of the country. The most extensive single bank network, as ofearly 1997, is that of NationsBank, which has more than 2,600 branches in a 16-state area bounded by New Mexico, Iowa, Maryland and Florida. In eight of these states it ranks first in deposits. KeyCorp, which owns banks in 12 northern states, will consolidate them into a single new bank that will operate "KeyCenters" in 28 cities ranging from Albany to Seattle. Their corporate goal, according to spokesman Bill Murschel, is to "transform Key away from an organization of a bunch of state-oriented companies to one more like Sears or McDonald's that really operates the same from coast to coast." It seems highly likely that further mergers will lead to one or more truly national banks within the next few years. Consolidation Bank holding company acquisitions across state lines have fueled the expansion of interstate banking. But the continuing wave of bank mergers has also involved major banks that were formerly competitors in the same market. For example, the four largest banks in California combined into two (Bank of America and Security Pacific, Wells Fargo and First Interstate); the four biggest banks in Boston also paired off (Fleet and Shawmut, Bank of Boston and BayBank); and three of the four biggest New York banks were reduced to one (as Chemical acquired Manufacturers Hanover before combining with Chase Manhattan to form the biggest U.S. banking company, with over $300 billion in assets.)As the mergers proceed, the biggest banks control an ever-larger share of the industry's total deposits. Between 1980 and early 1996, the deposit share of the 50 biggest banking companies rose from 37 percent to 57 percent.New products and services Banks have reacted to the loss of customers in their traditional lines of business by turning to activities that generate revenue in the form of fees rather than interest. As a result, taking in deposits and making loans is providing a progressively smaller part of bank revenues. For example, many banks now quickly sell almost all of their mortgage, auto, and credit card loans to investors. In this system, interest payments go to the investors, while the banks pocket fees that they charge borrowers to make the loan.New ways of earning fees range from providing sophisticated financial services for large corporate customers to mass-marketing a wide array of financial products such as insurance, mutual funds, or investment management. Norwest's CEO Richard Kovacevich, saying that "We're not in the banking business -- there's not enough revenue in the old-time banking business to make it a success," regards his company as a "retailer," and its branches as "stores" where staff trained in sales techniques focus on selling as many products as possible to each new or existing customer.Under the headline "For More Bankers "Bank" is a Dirty Word," the Wall Street Journal reported last November that some large banks have stopped using the word "bank" in their advertising and, in some cases, even their names, because they regard the term as "dated" and "limiting." Oe KeyCorp executive, for example, said "In the world of financial services branding, the word "bank" doesn't cut it."New delivery systems The proliferation of ATM's and 24-hour telephone centers, and the growing use of personal computers for electronic-banking, mean that more and more bank customers rarely set foot in a bank office at all. Others do their banking at one of the thousands of bank branches that now exist in supermarkets and other large stores. And as automated mortgage review systems proliferate, even loans to purchase or refinance a home can be made without human contact.Paradise Gained -- Not!Stopping the epidemic of bank failures that raged at the beginning of the 1990s was essential. But the primary reason for investors' current optimistic assessment of the banking industry's prospects is their perception that banks have shown that they can prosper in an environment characterized by continual change and relentless competition.The banks' success, however, has come at a heavy price for bank workers. As in other industries, competition and change have created stress, speed-up, and insecurity. Layoffs have proliferated as banks have introduced ever-greater automation, downsized in the quest for lower costs, and consolidated operations in the wake of mergers. It is hardly a coincidence that total employment in banking has fallen as profits and stock prices have soared. Between 1990 and 1995, bank employment fell 10 percent, from 2.25 million to just over 2.0 million, while overall employment rose by about 8 percent.Furthermore, the transformation of banking creates potential threats to the economic well-being of everyone. Although banks would like to see deregulation pushed even further, there are three critical reasons why regulation should be strengthened. Because banks are at the heart of the nation's financial system, their actions profoundly affect not only particular groups and communities, but also the stability of the overall economy.The primary worry of the Fed and other bank regulators is the possibility of another massive financial crisis like that which ushered in the Great Depression. The failure of one or a few major banks could destabilize the entire financial system. The system of bank regulation established in the 1930s was designed with this danger in mind, and the dismantling of that structure makes the banking system more vulnerable. As banks develop new products and expand into new businesses in search of greater profits, they also expose themselves to larger and more spectacular losses.Second, concentration of economic power within huge banks poses great dangers, including excessive political influence. Popular resistance to such power has been a recurring feature of U.S. history, and is the main reason why banks faced strict limits on geographic expansion. The unprecedented consolidation within the banking industry is made even more threatening by the prospect that mergers among banks, insurance compnies, and investment firms will create huge financial conglomerates.When a banking market is more concentrated it is easier for banks to increase the fees and interest rates that they charge while reducing the rates that they pay to their depositors. A recent study by the U.S. Public Interest Research Group (U.S. PIRG), for example, found that bank fees increased at twice the rate of inflation from 1993 to 1995. Banking regulators and the anti-trust division of the Justice Department, both of which must approve or disapprove proposed mergers, need to more aggressively oppose excessive concentrations of banks' economic power.A third major worry is that banks operated from distant headquarters will be unable and unwilling to respond effectively to local needs. Historically, locally-based banks have been at the center of local economic and civic life in almost every city and town, possessing detailed knowledge of people and companies and the power to act on this knowledge. Although these banks often failed to serve equally all of the neighborhoods and groups in their local communities (see box), they did recognize that their own well-being was tied to the prosperity of the local economy.When, for example, NationsBank does business in a 16-state region from its headquarters in Charlotte, North Carolina, the situation is dramatically transformed. Lending for local economic development or affordable housing construction simply cannot be standardized like fast food or discount store operations. Responsiveness to specific local needs inevitably suffers when local bank personnel must defer to faceless decision-makers in regional headquarters. More and more communities, including cities as big as San Diego, have seen control of their biggest banks change from local hands to out-of-state corporations. By the end of 1995, out-of-state bank holding companies controlled more than half of bank assets in 23 states and the District of Columbia. In the transformed world of banking, we need more vigilant and effective oversight to ensure that banks respond to the needs of local communities.What former Fed Chairman Arthur Burns identified ten years ago as "the ongoing revolution in American banking" cannot be stopped. But it needs to be shaped and directed, by a reinvigorated, and democratically controlled, regulatory structure, so that banks will operate in a safe, efficient, and responsive manner that serves the interests of all of us. Resources: Transforming the U.S. Financial System: Equity and Efficiency for the 21st Century, G. Dymski, G. Epstein, and R. Pollin (editors), Economic Policy Institute, 1993; The Bankers: The Next Generation, Martin Mayer, 1997; Quarterly Banking Profile, Federal Deposit Insurance Corporation, various issues.