What
is a Bank?
Banks
are places where people can keep their money. Most people use banks to save
money in their savings accounts and to pay money from their checking accounts.
Today, when a person earns money from their job, their paycheck is often electronically
deposited (put) into their savings or checking account. Then, he or she can pay
their bills by writing checks from their checking accounts or pay online where
their bills are electronically connected to their bank accounts. Banks also
give loans to people. People may use the bank’s money to buy new houses, cars,
or to start business among other reasons. The bank makes money from lending by charging
interest. In other words, people have to pay back more than they borrowed. This
amount depends on how risky the bank thinks the borrower is and how fast the loan
is paid back among other things.
One tension for anyone interested in
reforming the financial system is the universal recognition that modern
societies need banking. In the truest form, banks take savings deposits and,
rather than hiding that money in vaults, lend it out for productive purposes.
This provides credit for families, small businesses, corporations, and state
and local governments. Without banks, anyone looking to borrow money would have
to find their own wealthy individual with extra available cash—and if your last
name is not Romney or Rockefeller, that could prove an arduous task. Banks are
middlemen, but they serve a vital role that, at its best, complements economic
prosperity by making sure the best ideas get the financial support to grow.
Some U.S. banks, especially at the community
level, still employ this basic model today, taking deposits and making loans.
But our biggest, Wall Street-centered banks—the ones who hold the majority of
the nation’s deposits, slowly consolidating the banking system and growing ever
larger—don’t do a whole lot of banking anymore. They tend to focus, instead, on
generating profits through a host of other complex methods. But in their
absence, lending doesn’t go away; it merely filters down to a different set of
less-regulated intermediaries, typically known as the shadow banking sector. (Its nickname
perfectly illustrates the core problem with its prominence: anyone concerned
about the safety of the financial system does not want its critical activities
happening in the shadows.)
The “big six” Wall Street mega-banks—Bank of
America, JPMorgan Chase, Wells Fargo, and Citi, along with investment banks
like Goldman Sachs and Morgan Stanley—take deposits these days almost as an
afterthought. It gets them into communities (you can view bank branches as
little more than building-sized billboards for more profitable financial
services), and, more important, it unlocks federal safety net programs like
Federal Deposit Insurance Corporation (FDIC) insurance and the “discount
window,” the Federal Reserve’s program of low-interest loans. Mega-banks assert
that they actually lose money on small deposits, and
while we shouldn’t take this claim too seriously, it’s clear that deposits
are not their primary concern.
With shadow banks making more and more traditional
loans, the consequences will be far graver, especially because shadow banks are
so intertwined with traditional banks.
The other mainstay of traditional banking is
lending—handing out money to be paid back at a set interest rate. And while
mega-banks still make a lot of loans, they have basically determined that they
can’t turn enough of a profit simply by sitting back and collecting interest.
Loans to businesses represent just 11.5 percent of bank balance sheets,
according to the St. Louis Federal Reserve. Loans to small businesses have shrunk for years. And overall bank lending to
individuals and businesses remains stuck below 2008 levels.
The bigger banks make fewer and fewer residential mortgage loans,
and they hold even less of them in their portfolios; government-owned Fannie
Mae and Freddie Mac own or guarantee 90 percent of all new mortgages. And
mega-banks have sold off hundreds of billions in mortgage servicing rights, so a dwindling
number of people write their mortgage check out to a bank. Bank of America, the
second-largest bank by assets in the United States, has quietly exited the mortgage business altogether on
a number of fronts, with other big banks joining them.
Banks don’t even lend much anymore to each
other to cover short-term transaction needs, once a major function. The New
York Federal Reserve finds that deposit-taking banks went from
60 percent of all interbank loans in 2006 to 26 percent at the end of 2012. The
Federal Home Loan Banks, another government-created enterprise designed during
the Depression to provide financing for housing, now controls most of the
interbank lending market.
In fact, interbank lending exemplifies why
mega-banks don’t rely on traditional techniques to turn profits. The Federal
Reserve began paying banks “interest on excess reserves” in fall 2008,
essentially paying banks to park their money. Banks figured out that they could
borrow cheaply from government entities like the Federal Home Loan Banks, and
then receive a higher rate of cash from the Fed on their excess reserves,
literally making money while doing nothing. If they
flip cheap borrowing into U.S. Treasury bonds, which are more lucrative than
interest on excess reserves, mega-banks can make even more money with no risk.
This easy cash sustains the real profit model
for today’s mega-banks: speculation. Trading revenue at investment banks like
Morgan Stanley and Goldman Sachs account for a far higher proportion of revenues than
traditional investment bank activities like raising money for new businesses.
And the biggest five mega-banks hold over 90 percent of all contracts in
the $700 trillion market for derivatives, the second-order bets that
accelerated and magnified the financial crisis. In effect, the “arbitrage”
opportunities to capture risk-free money funds the speculative trading, where
the real money lies. This runaway search for profit has contributed to the
financial sector tripling in size since the 1940s, with six
banks controlling two-thirds of total financial
assets.
So if mega-banks derive less and less of
their profits from lending, and if they are simultaneously consolidating the
industry—there are now under 7,000 banks in the entire country,
down from over 18,000 in 1985—the question becomes, who is doing the rest of
the lending?
The answer is hedge funds, private equity
firms, and other asset managers, which raise money from high-net worth
individuals and institutions like pension funds, and make investments on their
behalf. They collectively control over $53 trillion in assets, according to
the Treasury Department’s Office of Financial Research, up 60 percent over the past five years.
And lately they’ve poured a lot of that money into lending. The OFR report
found that these asset managers effectively perform many of the same services
as traditional banks, with the difference being that the risks they take, and
the borrowed money they use to take them, are largely shielded from view.
In 2011, the San Francisco Fed estimated that large companies get 75
percent of their credit from capital markets with these types of transactions.
The numbers are similar for medium-sized businesses. And smaller
businesses have seen a surge in subprime loans, mostly from
non-bank financial institutions. Shadow lending from non-bank sources hit record levels last year, especially to
those with shaky credit scores. Even “peer-to-peer” lending platforms have
cropped up, with completely unregulated entities matching borrowers and
investors, the very role of traditional banking.
This raises several concerns. First of all,
contrary to the idea that more competition drives down prices, shadow lenders charge more for their services,
essentially extorting from businesses that cannot secure loans from regular
banks. This exploitation and rent-seeking is depressingly normal in modern
finance: research from New York University shows that financial services cost more than they did 100 years ago.
Borrowers also must put up extensive collateral, including patents, to backstop
liabilities, making it a riskier practice.
Further, while the lack of oversight of
shadow lending reduces compliance costs for financial institutions, it leaves
regulators in the dark over what types of lending are happening in the system,
and what risks exist. This renders irrelevant what was a very intelligently
designed system for financial safety and soundness.
“The New Deal framework aligned every
financial activity, including who you lend to, with a specific regulator who
knew that business,” says Marcus Stanley of the coalition Americans for
Financial Reform. “Each regulator had government controls or a backstop meant
to keep it secure.” When that broke down with deregulation, you get the
situation we have today, where practically anybody can become a financial
intermediary. “It creates this endlessly powerful, endlessly morphing thing
where the market flows to wherever regulatory controls are weakest,” Stanley
says.
And of course, shadow lenders aren’t
interested in playing a supplementary role in the economy, but will place money
wherever it can generate the highest profit, threatening a rush of capital from
one speculative bubble to the next. No limits on the borrowing activities of
shadow banks means that they could ramp up their leverage, magnifying the impact of small losses.
Moreover, shadow lenders don’t have the kinds
of built-in safeguards that protect the entire financial system. A report from the Federal Reserve Bank of
New York notes, “the lack of access to sources of government liquidity and
credit backstops makes shadow banks inherently fragile.” If a shadow bank makes
a disastrously bad loan, without the need to carry capital to absorb the
losses, they would basically suffer with bankruptcy and collapse.
That’s fine if the rest of the economy isn’t
at stake. But with shadow banks making more and more traditional loans, the
consequences will be far graver, especially because shadow banks are so
intertwined with traditional banks.
“The story of the 2008 crisis is that you had
these firms outside of the public safety net and regulatory perimeter, but
hooked into banks inside the safety net,” says Stanley of Americans for
Financial Reform. “They all passed the hot potato of risk until nobody knew
where it was.” The financial crisis showed, as Federal Reserve Governor Daniel
Tarullo noted in a speech last month, that you cannot wall
off shadow banking from traditional banking, and this allows unregulated firms
like shadow banks to take greater risks, secure in the knowledge that they
would get bailed out if they found themselves in trouble.
Despite the central role of shadow banking in
the 2008 crisis, the Dodd-Frank law did little to reform it. It did include the
Volcker rule, named for the one-time chairman of the Federal Reserve, to try
and channel traditional banks back into lending and away from risky trading.
But while mega-banks initially reduced their sales and trading while they
determined how to comply with the new regulations, enterprising lobbyists uncovered plenty of exemptions to the restrictions,
allowing continued distribution of a wide range of securities, like government
bonds. Bank executives now believe the Volcker rule won’t have much impact on their revenues.
Indeed, there’s more fear that the gambling has returned to Wall Street banks
than that the Volcker rule has constrained their activities too much.
On the other side of the coin, Dodd-Frank
included a provision that would force systemically important non-bank financial
institutions into the regulatory framework, basically subjecting shadow banks
to the same oversight as traditional banks. But Marcus Stanley doubts this will
be effective. “Dodd-Frank says we have the power to designate them. I wish I
had faith in that,” Stanley says. This has been echoed by incoming Federal Reserve chair
Janet Yellen, who called shadow banking “a major source of unaddressed risk” in
a speech last year. Senators have similarly warned that the process of designating
non-bank firms is inadequate.
In particular, the Federal Reserve wants to reduce the dominance of shadow banking in
the short-term funding of traditional banks. Breaking that link, they say, will
reduce risks from that funding and close the perimeter of regulation and
government support. You can tell that regulators might actually be serious
about this, because the asset managers that control shadow banking have begun to object.
But cracking down on shadow loans to banks
may just shift that lending to other areas. While shadow banking activity has shrunk since the financial crisis, it
still represents over half of all traditional banking liabilities, and the
interconnected nature of Wall Street in general makes it hard to discern
between bank and non-bank activity.
One solution is to go back to the New Deal
era, with traditional banking on one side and trading on the other, and a solid
wall between them. Reinstating the Glass-Stegall Act, as senators like Elizabeth Warren have endorsed, would
serve this purpose, providing clarity to regulators who would not need to
understand multiple complex intricacies when monitoring a bank. “Banking should
be boring,” Warren has said.
The best you can say for shadow bank lending
is that it expands the opportunity for borrowers to access credit. But
reformers are quick to point out that this expansion comes with a cost, in
deregulation and the potential for outright fraud. Banks are uniquely equipped
to do banking because of the safeguards and procedures built up around them for
nearly a century. Casting this off into the wild west of shadow banking .
