July 07, 2009
Are Banks (still) Special?
Posted by Mehrsa Baradaran

Amid the banking crisis of the 1980s, Gerald Corrigan, then president of the Minneapolis Federal Reserve wrote an essay entitled “Are Banks Special?” in which he identified three characteristics that made banks special and which justified their regulation and protection by the Fed.

He states that banks are special because:

  1. They issue transaction accounts (i.e., they hold liabilities that are payable on demand at par and that are readily transferable to third parties);
  2. They are the backup source of liquidity to all other institutions, financial and non-financial; and
  3. They are the transmission belt for monetary policy.

He defined a bank as any institution that is eligible to issue transaction accounts. If the institution meets that definition, it would:

  1. Be eligible for government deposit insurance;
  2. Have direct access to the discount window;
  3. Be subject to Federal Reserve requirements; and
  4. Have direct access to Federal Reserve payment services, particularly the wire transfer system.

The essay and general desire to defend banking resulted from a deep identity crisis of US banking in the 1980s that led to widespread fears that the industry would not be able to compete with emerging financial markets and needed more freedom from regulation. The immediate threat was the growing securities industry that began offering significantly higher interest rates in highly liquid money market accounts with which banks could not compete with because of Reg Q and its mandated low interest rate. (The angst eventually led to the Monetary Control Act of 1980 and the Garn-St Germain Act of 1982, which eliminated many of the restrictions on banks’ deposit-taking and allowed banks to offer products that matched those of the securities industry.) The banking industry continued to develop and change over the next few decades through regulation and deregulation. Most of the natural changes, however, went in the direction of making banks less “special” by either allowing them to engage in more or through the development of other business entities that closely resembled them.

The Obama administration’s reform proposal has revived the idea of the "specialness" of banking and would eliminate some of the freedoms granted to banks and non-banks in earlier decades. It would also eliminate certain non-bank charters, subject bank-like entities to banking supervisors, and draw more solid lines around banks’ activities. In essence, the proposal would narrow the definition of bank as did Corrigan in the 1980s and justify certain activity limitations.

I wonder whether this isn’t a bit misguided and outdated. Our financial system is a lot more complex than it was in the 1980s and certainly more complex than in the 1930s when our current bank regulatory regime was crafted. Many commercial and securities firms are now engaged in activities that belonged strictly to banking years ago. And technology and the advancement of the securities market have made banks less “special” or worthy of special treatment. For example, Paypal, which is owned by ebay, issues transaction accounts similar to most banks, Western Union and Moneygram have also developed money transfer services previously dominated by banks. And aren’t our modern capital markets more like a "transmission belt" than banks? And are banks really the "backup source of liquidity to all institutions"?

Every banking crisis since the Great Depression has caused a revisiting of the major questions: how do we define a bank? How should it be regulated? And every crisis has yielded similar answers: a narrowing definition of banking and increased regulation in the form of activity barriers. Perhaps this time, we should ask different questions. Such as: what has changed since the last time? And do the old structures still make sense? I don’t think they do.

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