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Are Banks Special?

A Revisitation

March 1, 2000


E. Gerald Corrigan Former President (1980-1984)

At the request of Gary Stern, president of the Federal Reserve Bank of Minneapolis, I have been asked to revisit the essay—"Are Banks Special?"—I wrote almost 20 years ago when I was Gary's predecessor. While I readily agreed to undertake the revisitation, I must confess that a microscopic review of one's own writing 20 years after the fact is somewhat daunting. However, even with the passage of time, I can still recall with clarity the factors that prompted me to write the essay in the first place.

In large part, those factors centered around the widely held perception in the early 1980s that the competitive position of traditional banks was rapidly eroding, thereby calling into question how the banking and financial system of the future—including the monetary policy process—would work. In turn, those questions were prompting a range of other issues relating to the desired structure of the future banking and financial system, including specific questions such as the scope of activities that banks should be permitted to offer, and whether the separation of banking and commerce should be preserved.

In that time frame, then-Federal Reserve Chairman Paul Volcker and I often engaged in late-night brainstorming sessions about these and other issues. During one such session, I remember suggesting to the chairman that someone should write a "think piece" on these banking sector issues. In his usual style Chairman Volcker responded by saying, "Why don't you do it?" So, I did.

However, writing the essay, as Volcker anticipated far better than I, proved to be more difficult that I suspected. I can still recall going through what seemed like dozens of drafts in what became a painful and tedious test of logic and precision. I remain grateful for the support and help provided to me in that undertaking by Kathy Erickson, then a colleague at the Minneapolis Federal Reserve Bank.

While the initial publication of the essay produced a bit of a stir, it proved to have much more staying power than I would have imagined at the time. Indeed, eight to 10 years later I was surprised—and perhaps a bit flattered—to learn that both of my daughters encountered the essay on reading lists for courses they were taking in college. As for myself, by the time the essay was finished I was so sick of the subject that I never again glanced at it until Gary Stern asked me to write this article.

Clearly, a great deal has changed since 1982. However, in what I hope is not an overdose of intellectual self-delusion, I still find the core of the essay highly relevant and I still believe that banks are special. Further, I would observe that important parts of the philosophy embodied in the essay continue to command broad support and are, for example, reflected in the sweeping new banking legislation enacted in the United States last year. Finally, in reflecting on the severe banking sector problems that have been witnessed in so many countries—including the United States—over the past two decades, I believe that the stress the essay placed on the critical importance of what I called the "impartiality of the credit decision making process" was, if anything, understated.

The 1982 essay began with the assertion that there were three traits that made banks special. Building on those core traits, a simple, but formal, definition of a "bank" was suggested. A "bank" was defined as any institution that was authorized to issue deposits which were "payable on demand at par and readily transferable to third parties." Given the core traits and the definition of a bank, the essay went on to stipulate that public interest considerations associated with banking were such that only banks should have access to the full-scale public safety net for financial institutions as defined in the essay.

The three key traits of banks were: First, they offer transaction accounts as defined; second, they are the backup source of liquidity for all other institutions; and third, they are the transmission belt for monetary policy.

Clearly, the world of 2000 is not the same as the world of 1982. Yet, there remains a core of validity to these key traits of banks. Allow me to elaborate briefly.

  • With regard to transaction accounts, certainly there are many close substitutes for bank-issued demand deposits, the most important of which is the "checkable" money market mutual fund that was rapidly gaining popularity in the early 1980s. However, these substitutes do not meet the test of being payable on demand at par. Thus, while the competitive landscape continues to shift, there remains a critical aspect of the deposit gathering function which is unique to "banks."

  • With regard to banks as the backup source of liquidity, it is true, as recently observed by Fed Chairman Alan Greenspan, that the ability of capital markets to mobilize and allocate capital has changed dramatically and that capital markets and banks play complementary roles in the credit intermediation process, especially when one sector is having problems and the other is not or vice versa. However, it remains highly unlikely that nonbanks-whether financial or nonfinancial companies-can provide very large amounts of liquidity on short notice, such as the surge in bank funding of the securities industry which occurred at the time of the 1987 stock market crash.

  • As to the transmission belt for monetary policy, it is undeniable that the monetary policy process—and its linkages with the economy—have changed considerably over the past 20 years. Yet it remains largely true that most monetary policy targets and indicators (the federal funds rate or its equivalent in other countries and most measures of the "money supply") remain, to a very considerable degree, uniquely associated with banking institutions. However, recognizing that interest rates are the cutting edge for monetary policy, it follows that financial markets generally, and nonbank financial institutions specifically, play a much larger role than they once did in the transmission of monetary policy changes to the economy, even if we do not fully understand the precise workings of these transmission channels. In other words, while the monetary policy channels and linkages have changed, the role of banks remains central to the monetary policy process even if less so than in the past.

In the 1982 essay, a direct connection was drawn between the special traits of banks and access to the financial safety net defined as deposit insurance; the account, credit and payment facilities of the central bank; and a heightened degree of fully consolidated official supervision. This, of course, raises the question of whether so much has changed since 1982 as to either narrow or broaden the class of institutions having access to the safety net, or to redesign certain aspects of the safety net, or both. Directly or indirectly, these questions have been at the core of the debate about legislative reform of the financial system for most of the past two decades.

At the time the essay was written it was widely recognized that the basic statutory framework governing banking and finance in the United States was in need of reform. However, there were considerable differences of opinion as to how far that reform should go. For example, there were many, myself included, who were distinctly uneasy about the prospect of the full-scale repeal of Glass-Steagall. Similarly, for many who anticipated the scope and cost of the savings and loan crisis, there were major questions about the wisdom of authorizing broad new powers—including full-fledged real estate development authority—to S&Ls.

By the mid to late 1980s, the forces of competition and technology made it clear that "the finger in the dike" approach to Glass-Steagall was, as a practical matter, unworkable. Nevertheless, several efforts aimed at legislative reform failed. By the late 1980s and early 1990s, the focus of attention shifted as major banking sector problems—including the seriously weakened condition of a number of very large banks—gave rise to heightened concerns about the stability of the system as a whole. In some ways, this time interval was the high-water mark for those who favored combining banking and commerce. The argument, in a nutshell, was that only such a step could provide the huge amount of fresh equity needed to recapitalize the banking system, especially several of the nation's largest banks. This environment helped to trigger the enactment of the Federal Deposit Insurance Corp. Improvement Act of 1991. This important legislation accomplished some of the needed redesign of the safety net, but it was essentially silent on issues relating to banking structure.

Even as the banking system regained its health and the financial condition of most major banks and nonbank financial institutions improved dramatically, efforts aimed at legislative reform remained stymied. Finally, in late 1999 Gramm-Leach-Bliley (GLB) was signed into law by the president.

By any measure, the provisions of GLB are sweeping, even if it is true that in important respects it essentially ratified what markets and regulators had already done. In the debate leading to the passage of GLB, there were three core issues relating to the 1982 essay which had to be resolved. They were: first, whether expanded activities for banks should be conducted through operating subsidiaries of banks or through subsidiaries of a bank holding company; second, whether, or to what extent, to alter the doctrine regarding the separation of banking and commerce; and third, whether to preserve the narrow linkage between "banks" and full-scale access to the so-called safety net as defined earlier. The 1982 essay answered these questions by: (1) favoring the bank holding company model; (2) strongly opposing the breakdown of the separation of banking and commerce; and (3) preserving the narrow link of extending the full-scale safety net only to banks.

Relative to these three central issues, GLB stacks up rather well. It preserves the narrow link between banks and the safety net, and it rejects the blending of banking and commerce while providing some added flexibility for merchant banking. With regard to the bank subsidiary vs. bank holding company question, GLB incorporates the compromise struck by the Congress, the Treasury Department and the Federal Reserve. Specifically, GLB permits certain activities (based primarily on their "closeness" to banking and their risk characteristics) to be housed in bank subsidiaries while other activities (including merchant banking) would be housed in subsidiaries of the bank holding company. Important details regarding these arrangements have yet to be spelled out in regulations.

The debate between the bank subsidiary vs. bank holding company models involves several issues, but the central issue relates to whether one approach is superior to the other in insulating the safety net from problems that might arise outside the bank but within the group as a whole. I have never believed, and still do not believe, that either model can provide fail-safe insulation. Thus, the question is which approach provides the greatest assurance that the insulation will survive the test of severe stress. I, for one, remain firmly of the view that the holding company provides the greater assurances in this regard. But, we should not delude ourselves. Fail-safe insulation is an outright fiction and that is why effective and enlightened consolidated supervision of banking groups and holding companies is so essential.

In summary, to a very considerable degree, GLB seems to acknowledge that banks are special. Indeed, the Act is both powerful and progressive in providing a coherent framework to guide the next phase of the evolution of banking and finance in the United States. Of course, GLB will not be the last word on this subject. The still-accelerating pace of technological advances in banking and finance ensures that outcome.

In the meanwhile, the pattern of further consolidation in banking and finance will continue. Hopefully, that process will evolve in an orderly fashion, including one in which the argument for combining banking and commerce has been put to rest for a long, long time to come. Indeed, if there were any lingering doubts about the potential costs of such arrangements, the havoc produced by these arrangements in so many countries in recent years should serve as "Exhibit A" in defense of the separation doctrine.

More broadly, the financial strength, competitive energy and global leadership of U.S. financial institutions have recovered sharply from the threatening days of the late 1980s and early 1990s. Yet, the financial system continues to encounter periodic bouts of severe volatility and instability. And, despite massive efforts by both the official and private sectors aimed at crisis prevention and crisis management, the system remains vulnerable. This underscores the case for enlightened management and supervision of banking institutions which will encourage a gradual but decisive shift to greater reliance on market mechanisms and less reliance on de facto official intervention.

E. Gerald Corrigan is managing director at Goldman, Sachs & Co., New York. He serves as co-chair of both the firm's Risk Committee and the Global Compliance and Controls Committee. Prior to joining Goldman Sachs in 1994, Corrigan was chairman of the Basle Committee on Banking Supervision, the first American to hold that post. In addition, he spent 25 years with the Federal Reserve System, most recently as president and chief executive officer of the New York Fed, following five years as president of the Minneapolis Fed.

Also see: The 1982 Annual Report essay, "Are Banks Special" and the Region interview with E. Gerald Corrigan, Nov. 1990.