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Safeguards to the U.S. Banking System Should Not Be Dismantled

Top of the Ninth

June 1, 1990


Melvin L. Burstein Senior Vice President and General Counsel
Safeguards to the U.S. Banking System Should Not Be Dismantled

"...along with the dismantling of these archaic laws, public policy officials concerned over U.S. competitiveness must overcome unfounded trepidation over the separation of finance and commerce..."*

—L. William Seidman, chairman
Federal Deposit Insurance Corp.

*Testimony before the International Competitiveness Task Force, Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, March 22, 1990.

In testimony before Congress, Mr. Seidman said that without his recommended changes to U.S. banking structure and powers, the U.S. banking system will lose its ability to compete in the global financial market. That loss will "weaken the viability of our banking system and ... the economic strength of our nation worldwide," he maintains.

Mr. Seidman, who is not alone in his assessment, would go further than almost anyone else in restructuring the U.S. banking system and enlarging bank powers. He urges "dismantling of ... archaic laws" —including Glass- Steagall, which separates commercial and investment banking, and the Bank Holding Company Act, which separates banking and commerce—to enable the formation of so-called universal banks.

I have to wonder if Mr. Seidman and others have lost sight of why banks are subject to these and other laws regulating the way they do business. The thesis of an essay by E. Gerald Corrigan, the immediate past president of the Minneapolis Fed and current president of the New York Fed, published in this bank's 1982 annual report, captures what I believe is the reason for such laws—banks are special. The banking system has a special place and set of functions in our economy.

The "archaic laws" Mr. Seidman refers to, among others, were put in place not to develop the largest or the most profitable banks in the world, but to provide a safe and sound banking system for the benefit of the U.S. economy. Anyone advocating major changes to banking structure and powers should have the burden of proving the need to do away with the legal structure intended to protect the U.S. economy from a major disruption in the banking system.

In 1913, Congress passed the Federal Reserve Act, the first piece of banking legislation of this century to address the country's repeated banking panics. Among other things, it established a central bank system to provide liquidity to banks as needed to provide stability.

In part because the Federal Reserve didn't properly use its power to provide liquidity, thousands of banks failed during the early '30s. As a result of these mass failures, Congress enacted the Banking Acts of 1933 and 1935, which included the National Bank Act, Glass-Steagall, the federal deposit insurance system and significant amendments to the Federal Reserve Act. To further protect the banking system, Congress passed the Bank Holding Company Act of 1956 to separate banking from commerce. In 1970, that law was amended to include corporations that owned even a single bank.

Like public utilities, banks are not allowed to operate unfettered in the marketplace; rather, they are given a limited market advantage of a geographic and activities franchise. In addition, they derive a market advantage from the federal safety net of access to borrowing from the Federal Reserve and deposit insurance. These market advantages must still have value, because in spite of all the market opportunities allegedly now denied U.S. banks, I am not aware of any bank that has relinquished its charter to engage in other business.

No one familiar with the yet unresolved thrift problem and numerous and substantial bank failures of the 1980s should have any doubt about the economy's vulnerability to misadventures in the banking system. Driven, at least in part, by deregulation of some activities and fueled by the problems inherent in deposit insurance, these misadventures caused the insolvency of the Federal Savings and Loan Insurance Corp., the diminution of the reserves of the Federal Deposit Insurance Corp. and a huge, but yet undetermined, addition to the federal deficit.

I have reflected at length on the alleged competitive problems confronting U.S. banks to understand what could justify the advocated changes in spite of these problems of the '80s. The allegations are unsupported by empirical evidence, and I don't believe the proponents for change have met the burden of proof that should be required of them.

Much is made of the dramatic changes that have taken place in the global marketplace in the last decade. Not to trivialize globalization, as the process is often called, it isn't something that began in the 1980s. It began with the first people to "go down to the sea in ships," uncertain of how far they could travel before falling off the edge of the earth. Technology has increased the scope and velocity of international trade over time, but the changes of the 1980s are only marginally significant when viewed in historic perspective. Certainly, the '60s and '70s were not the dark ages of international business and finance.

If there is reason to worry about globalization, however, it should not involve the ability of U.S. banks to compete, but the risks related to the growing interdependence of markets. Global financial markets are vulnerable to the consequences of risk being transmitted from one to another. That being the case, it seems to me that the structure in place to protect the U.S. banking system is more important than ever.

Why this growing anxiety over globalization? Probably because in the past 30 to 35 years, the relative position of the U.S. economy in the world changed as several other countries emerged as major economic powers. In addition, U.S. trade imbalances driven by large budget deficits emerged in the 1980s. While these changes are not the result of the alleged competitive disadvantage of U.S. banks, many in the United States have become sensitive to real or perceived unequal treatment of U.S. businesses, including banks. This is especially true with regard to Japan. Similar concerns are raised by the unification of the European Economic Community (EC) in 1992.

What is the evidence that U.S. banks are unable to compete in this environment? The only empirical evidence offered to demonstrate the competitive disadvantage of U.S. banks seems to be their size relative to other banks in the world, and the increasing market share of Japanese banks throughout the world, including the United States.

U.S. banks are no longer among the largest in the world. Only one, Citicorp, is among the 25 largest, and Japanese banks comprise the 10 largest and 17 of the 25 largest. Much of the decline in the relative size of U.S. banks as compared to foreign banks can be traced to the substantial decline in the dollar in relation to the yen, deutsche mark and the other major currencies, between 1985 and 1988.

In addition, the U.S. banking system bears little or no resemblance to the banking systems of most other industrialized countries. The assets of the U.S. banking system are dispersed among almost 13,000 banks created by 51 chartering authorities (53 supervisory agencies). The assets of the banking systems of most other industrialized countries are concentrated in relatively few institutions created by a single chartering authority in each country. Even though movement toward interstate banking is reducing the number of U.S. banks, it's doubtful that even full interstate banking will result in a system that resembles those of Germany and Japan.

In any case, does size matter? Are bigger banks better able to compete? I assume the concern for the competitiveness of U.S. banks is toward profitability. By traditional measures such as return on assets and return on equity, U.S. banks are more profitable than much larger Japanese banks. There certainly is no evidence that efficiency or economies of scale are achieved by growing from a $200 billion to a $300 billion bank. Indeed, there is no correlation between asset size and the profitability of an institution.

With regard to concerns about market share, it is often said that U.S. banks can't compete with Japanese banks because the Japanese are willing to make loans on very small margins just to gain market share. As a regulator concerned about safety and soundness, I would not want U.S. banks competing for such credit in the interest of gaining market share.

Also, while it appears that Japanese banks have a lower cost of capital and some liabilities, that is not a function of bank size. Regardless, whatever motivates Japanese banks to make lower cost loans to U.S. businesses, I would think that those responsible for public policy would be pleased with the resulting benefit to the U.S. economy.

Even those who advocate more bank powers are concerned about the exposure of the federal safety net. That concern should be heightened by the doctrine of "too big to fail," which is based on the notion that the economy could not tolerate the failure of a large bank. Although many support the doctrine, I doubt that anyone can be very comfortable with it. Given that, why should the United States be so anxious to allow banks—that are already too big to fail—to expose the safety net to greater risk by becoming even bigger? If the bank that is too big to fail is a universal bank, could the bank and its non-bank activities really be unraveled when it came time to employ the safety net?

It is also asserted that countries such as Japan, soon to be followed by the EC, create legal impediments that put U.S. banks at a competitive disadvantage with foreign banks, both in the United States and in the host country. What are the legal impediments to U.S. banks competing with foreign banks? U.S. law permits U.S. banks to engage, directly or through holding company subsidiaries, in most of the activities allowed to banks in the host countries. Similarly, foreign banks aren't allowed to do anything in the United States that is prohibited to U.S. banks.

Nevertheless, competitive disadvantages pose safety and soundness risk, some say, because U.S. banks that are losing business to non-bank competitors and foreign banks must take on riskier loans to maintain profits. Additional powers are intended to enable U.S. banks to diversify risk by competing for financial services currently barred to them.

Diversification of risk is a sound practice, but I have to question the wisdom of diversification through transactions of at least undetermined risk to safety and soundness. As for profitability, the argument is flawed because there are many U.S. banks of all sizes doing quite well from traditional banking business. The recent huge losses experienced by some U.S. banks appear to be related to their disregard for sound underwriting principles rather than competitive disadvantages.

In sum, the proponents of change have not made the case that would justify dismantling a legal structure intended to protect the U.S. economy from a disruption in the nation's banking system, particularly if changes add uncertain risk. There are, indeed, more pressing issues related to bank structure about which Congress should be concerned—deposit insurance reform, for example—but the issue of the competitiveness of U.S. banks is not among them.

Melvin L. Burstein is the senior officer over banking supervision at the Federal Reserve Bank of Minneapolis.