More than five years have now passed since the financial crisis, and the financial reform agenda centered on banking is well underway. But is it on the way to the right destination, and, if so, how far along is it?
Answers to these questions vary widely. President Obama declared in his 2012 State of the Union address that “we’ve put in place new rules to hold Wall Street accountable, so a crisis like this never happens again.” Done deal; problems solved. Others, partisans and scholars alike, believe that none of the factors that led to the crisis has been addressed adequately. In November, Senator Elizabeth Warren challenged the President to break up the four largest U.S. banks, which, she pointed out, are now 30 percent larger than they were before the crisis.
Most observers are somewhere in between, including, apparently, the President, since his call this past summer to speed up and deepen the reform agenda blurs the confident clarity of his “never happen again” statement. No one denies that the political and operational challenges to implementing new rules already passed are many, and no experienced observer can rule out twists in the implementation process that can divide a rule’s consequences from its authors’ intentions. So then where are we in our effort to create a banking systems that will not generate a repeat of the crisis that shook the world on a scale not seen since the Great Depression?
The short answer is that our banking and broader financial systems are on a path to prevent a recurrence of 2008, but our reform undertakings are incomplete. One reason is that the reform agenda thus far has been backward-looking at a time of vast and accelerating innovation. Past decades saw the transformation of banking into a universal model where trading, securitization and financial engineering seemed to overwhelm the simple, customer-based loan business. Several structural reforms are designed to take banks back to a less racy model or, as it is popularly articulated, to make banking boring again. But that reform model is focused on institutional dynamics already in place, not on a whole new universe of possibilities for deposit-taking and maturity transformation that might occur through internet-based models supported by modern information technology.
It is not wrong to want to avoid a repeat of 2008, but we need to be asking ourselves whether we want to prevent banking, by fiat, from joining other retail business sectors in a fundamental transformation. If we do that, we may never find out who will become the Amazon of American banking, whether a novel, deposit-based institution or a new form of capital market organization that can change the banking business to match the internet age. So we need a reform agenda that is balanced between preventing a recurrence of past errors and allowing space for innovations based on new technology.
We in the United States also need to remind ourselves that this is not an exclusively American issue; banking and finance are global and globalized operations, and our innovations must occur in ways compatible with international rules. Attentive Americans have heard of the Volcker Rule and its laborious path to becoming a reality, but how many have heard of Basel III, the framework for this change?
Are Banks Safer?
In the most recent annual report of the Bank for International Settlements, known as the BIS, there is a useful overview of banking reform efforts. The basics, of course, are to clean up impaired assets, strengthen the balance sheet and set up a business model with sufficient earnings. To follow what is going on, one needs to gain familiarity with the “architecture” of global banking supervision and regulation.
In 2010–11, under the aegis of the BIS, the Basel Committee on Banking Supervision (BCBS) brought a third stage of reform, Basel III, which stands at the center of the international reform agenda. The BCBS’s mission is to develop global regulatory and supervisory standards for banks as they relate to macroprudential concerns—in other words, issues that affect the overall functioning of the economy, such as capital adequacy, stress testing and liquidity risk. Thus, Basel III increases loss buffers, emphasizes higher quality capital in its requirements, and better captures the full scope of bank risk with a ratio to link capital to the size of the risk assets, a capital overlay for systemically important banks, a countercyclical capital buffer and standards for liquidity, which help ensure that cash is available when needed. The implementation of Basel III began last year, but the very long transition periods granted can make matters slow-going. Regulatory authorities are moving faster.
The BIS also hosts the Financial Stability Board (FSB), which “coordinates the work of national financial authorities and international standard-setting bodies and develops policies to enhance global financial stability.” The FSB/BIS is the venue where officials monitor implementation efforts across jurisdictions. FSB membership consists of senior officials from finance ministries, central banks and supervisors, along with senior representatives from the European Central Bank (ECB), the European Commission, the international financial institutions and standard-setting bodies. It is an important group standing at the center of global financial reform. In the wake of the crisis, a key area of the work has been focused on the list of banks that are rated “systemically important” globally.
The question of how much capital a bank should hold in reserve is always a centerpiece of reform efforts, as well it should be. When Lehman failed, its leverage was more than 30:1, with $639 billion in assets and $619 billion in debt and a narrow slice of equity to bring the two sides of the balance sheet into equivalence. That degree of leverage meant that an asset value markdown during a crisis could quickly spell insolvency, the prospect of which created liquidity problems for Lehman when it tried to fund itself through the interbank market.
There is a difference between absolute capital held in reserve and capital-ratio requirements that set a level of capital in relation to the so-called risk assets a bank holds. The BIS has favored the supposedly more fine-tuned, risk-adjusted measures, but it appreciates that the ratio approach can be no better than the quality of the measurement that goes into the denominator, itself something of an imprecise art.
For the time being, the caveat has been overtaken by the fact that, on a worldwide basis, banks have improved their capital ratios at a faster pace than that required by Basel III. Common Equity Tier 1 (CET1) capital for the large international banks had risen to 8.5 percent of risk-weighted assets by mid-2012, higher than the minimum mandated buffer of 4.5 percent plus the 2.5 percent surcharge set out for 2019. Among the 18 largest U.S. bank holding companies, tier one capital averaged 11.3 percent at the end of 2012, more than double the level at the end of 2008. From these numbers, one can appreciate why some outside observers think Basel III is too lax in its standards. Some have claimed that Basel III represents a lowest common denominator of the global banking systems, which are nationally represented in the committees.
As attention moves to implementation, the BIS this past year gave special attention to critiques of the risk-weighted basis for capital. Having risk-sensitive rules based on highly complex approaches to modeling can backfire if the methodology turns out to be simultaneously taken for granted and erroneous. Knowing this, BIS representatives took action. First, at the end of October the BCBS laid out a standardized approach to calculating bank risks designed to stand side by side with each bank’s in-house system, with the hope that it might become a minimum standard for capital holdings. Second, the BIS turned attention usefully to adding a risk-insensitive measure: “leverage ratio”, which is the simple measure of regulatory capital to total assets. The combination of these measures adds to the best forecasting of the likelihood of insolvency.
As a means to prevent systemic risk, the BIS puts little store in the various approaches underway to restructure national banking systems. Bank reforms in national arenas impose constraints on bank activities, such as securities underwriting or trading, and the reasons for such constraints are both politically variable and indirect in their effects on solvency—hence hard to predict or influence. International regulations instead set capital and liquidity requirements aimed at limiting the potential for bank failures with systemic consequences. When it comes to very large national banking systems, like those of the American and European Union, what happens has importance that radiates worldwide. So let us look briefly at these two critical banking systems in turn.
In December 2011, the U.S. Federal Reserve announced that it would implement substantially all the Basel III rules and that the rules would apply not only to banks but also to all non-bank financial institutions with more than $50 billion in assets. With the passage of the Dodd-Frank law in 2010, the Basel implementation has dovetailed with Dodd-Frank’s, creating interesting patterns that have gone largely unnoticed by the public in the United States. In mid-July 2013, the Fed, along with its partner supervisory agencies, announced the final rules on important elements of the reform agenda. They also proposed new rules on leverage (for final action in March). And in October of last year, the Fed proposed standards for holding liquidity. All of these decisions either stem from or had to be reconciled with Basel III.
The rules already finalized increase both the quantity and the quality (which is to say the assurance of availability when stress occurs) of regulatory capital by setting strict criteria for regulatory capital instruments and raising the minimum capital to risk-weighted ratios. The rules include a “capital conservation buffer” to assure the build-up of capital in so-called benign times as insurance against economic downturns that deplete capital. They also improve the methodology for calculating risk assets. There are supplementary leverage ratios and countercyclical capital buffers for the large and international, systemically important banks. Fed Governors, notably Daniel Tarullo, view these rules as both a consolidation of progress made since the crisis in strengthening banks and a fulfillment of Basel III obligations in a way that gives the United States standing in pressing others for progress.
These rules also fulfill Dodd-Frank requirements by extending the stress tests to the full list of the “dozen or so banking organizations with greater than $50 billion in assets.” The use of stress tests on a regular basis, with the results made public, is an important innovation in supervision in large part because it is not just backward-looking in assessing the balance sheet but forward-looking in testing its resilience through stressful scenarios.
The big news of this past summer, however, was not the final rules but, rather, new rules jointly proposed for public comment by the major U.S. bank regulators to “rein in” the biggest banks. The proposal would increase the capital reserve ratio requirement on the largest institutions in relation to absolute size, not on a risk-adjusted basis alone. While Basel III also calls for this additional leverage ratio, it requires only 3 percent by a 2018 deadline. Prospective U.S. regs would require roughly double the capital: 5 percent for the holding company and 6 percent for any FDIC-insured bank subsidiary. That would sum roughly to an additional $90 billion in reserve capital across the eight largest U.S. bank holding companies, with a deadline of 2018.
The big banks were not pleased, and mobilized their usual assets to oppose the new regulations going into effect. Congress has no direct role in this process, which entails regulators putting out new regulations for public comment before final adoption. In October, the Federal Reserve went further with new liquidity requirements, again focused on the largest banks, requiring holdings of high-quality liquid assets in volumes prescribed to be sufficient to survive thirty days of a stressful period in the financial markets and mandating this change in stages through January 1, 2017. For non-experts it is a confusing set of standards and deadlines, but the bottom line is to shore up the safety of the U.S. banking system through higher capital and better quality liquidity in the coming few years.
Other tasks underway include putting final rules in place for enhanced prudential standards both for the over-$50 billion banks and for non-bank financial companies designated by the Financial Stability Oversight Council (an interagency group chaired by Treasury) as systemically important (GE Capital and AIG were designated as such in the July rules). These requirements are graduated by size and encompass capital, liquidity, stress testing, single-counterparty credit limits and remediation plans, along with risk management and resolution planning requirements. The resolution schemes (called OLA, for orderly liquidation authority, or “living wills” in the vernacular) envision imposing costs on shareholders and creditors and removing management while allowing the going concern part of the bank to continue functioning.
The issues in the European Union are vastly more complicated politically than they are in the United States. This is why even the good advice it sometimes gets ends up having less impact than elsewhere. The Liikanen “Report of the European Commission’s High-level Expert Group on Bank Structural Reform”, chaired by Bank of Finland governor Erkki Liikanen, concentrates on “too big to fail” and suggests preventing contagion and the cross-subsidization of risky activities by placing different classes of lending activity in specific subsidiaries. That is excellent technocratic advice, but Europe faces political problems in reaching consensus on rules, which would apply to all the constituent national systems.
The main reason for the complexity of the European Union’s situation is that its negotiations encompass competing national interests, and even competing objectives within individual countries. All EU members want to maintain national authority over the resolution of failing banks within their own countries, but at the same time many are jockeying to see how much of the cost of resolution they can offload onto the backs of the richer countries. Nominally, the discussions proceed under the rubric of formulating a “banking union”, but no such union has ever been in prospect. The ECB has been handed an important (and not necessarily welcome) role as the supervisor of an entity that does not and will not soon exist—not an enviable task. As a first step, it will begin stress testing the largest institutions. But the tests are only meaningful if there is an authority in place to resolve insolvent institutions, and there is no such single authority in the ECB or anywhere else.
The European Union has successfully sought agreement on rules that would govern a resolution authority across the European Union (including the non-eurozone countries, particularly the United Kingdom). The agreed rules only come into effect in 2018, but they will at least to some extent shape responses from now on. The basic idea is to shift costs from taxpayers to creditors, but this is a problematic proposition. The Cyprus crisis response, in which even small depositors seemed at risk as the authorities improvised against a repetition of an officially sourced Greek bailout, has left officials seeking to avoid a repetition of either scenario.
The question, really, is not who gets bailed out in a crisis but who gets bailed in. For the European Union, that generously includes debt-holders, shareholders and substantial corporate depositors, most of whom are domestic. Moreover, the implementation of any resolution would have to take place in the absence of a central resolution authority with its own funding. In December 2013, EU leaders toasted an agreement that fell far short of the goal. They agreed only to rely on private investors and national pots of money, funded through bank levies, which will evolve into a mutual fund over the course of ten years. But that fund will total only €€55 billion when it becomes fully operational in 2026; that’s a paltry sum to backstop European banks. A common EU safety net was left for a later negotiation.
The fragmentation of risk by country remains a challenge to the union of Europe. As Wolfgang Munchau has pointed out, bail-ins only shift stress to foreigners if shareholders and bondholders are foreign, but most European banks have become more national since the crisis. So if the Spanish Central Bank, say, bails in Spanish bondholders, all the risk remains in Spain—and hence the problem is not solved, merely shuffled around a bit. The ratio that matters is not public debt to GDP, but the much higher level of total external debt, public and private, domestic and foreign. Put a bit differently, the link between monetary union and fiscal union is hard to evade. Without a fiscal union to fund losses across the national banking systems, a true banking union is impossible. But without control over another government’s budget, why would any rich country stand ready to bail out the banking systems of one in stress? Lots of ink gets spilled on the virtue of alternative approaches, but politics is overwhelmingly driving the outcome.
As things stand, given the diversity of EU members’ fiscal and banking circumstances, countries with weaker economies and fiscal stress will bail in domestic creditors, but stronger countries with the wherewithal to intervene with public funds may keep taxpayers on the hook. The summer’s harvest thus made for an unappealing menu of choices, and that became obvious as the ECB took up the challenge of the bank reviews this past autumn. The ongoing tension became apparent between the EU support for extensive bail-ins versus the ECB’s calls for moderation in requiring debt holders to become equity providers in solvent but undercapitalized banks. Piercing the veil, the two intertwined issues remain: how much Germany and other “northern” countries will be called upon to provide support to the weaker financial systems in the eurozone, and how much support will be required in the wake of the stress tests and supervisory review at the ECB. The situation suggests the strong need for further EU member negotiations before the results of the stress tests are released, lest the ECB feel constrained from reporting bad news.
The challenge in the United Kingdom is, of course, less complex than for the euro-denominated banking systems. It is currently implementing the Vickers recommendations (named after Sir John Vickers), which will ring-fence core banking activity and move trading and underwriting to separate entities in the holding company, similar but less organizationally severe than the American Volcker rule mandate.
In addition to ring-fencing structural changes, the recommendations add a requirement for more reserve capital and include strong proposals on bank remuneration. Bonuses to bankers have deferred payouts for as long as ten years, and the funds can be withdrawn if needed to avoid insolvency. Moreover, the commission recommends civil and even criminal penalties for “reckless” conduct. The Brits seem better than we Americans at calling a spade a spade and shaping reform to change the culture directly through incentives for senior bankers to take care. Locking up remuneration is a halfway house back to the norms of banking when private ownership by partners assured prudential behavior. Those were the good old days in the United States.
So plenty has gone on in the past five years, much of it very useful. The consensus view now favors a complementary approach to capital requirements that combines both a risk-weighted minimum capital ratio and an overall balance sheet ratio. Within the different major banking areas there is also a desire to hive off the part of so-called banking that serves the traditional purposes of lending as opposed to broader capital-market functions. Bank bailouts are seen as taxpayer subsidies to bank stakeholders, so efforts are afoot to bail in institutional depositors, along with management and shareholders, to incentivize prudential behavior.
So far, so good, but there are problems. First, policy differences between Europe and the United States have become gnarly. U.S. officials want to subject the U.S.-sited operations of foreign banks to U.S. rules, which has led to both polite calls for cooperation and threats to reciprocate against U.S. banks doing business in Europe. Second, differences also persist over the amount of capital to be required, derivatives regulation, criminal prosecution of bankers and even the proper forum for negotiating agreements. Different standards enable bankers to seek refuge by asking for a level playing field, which, given their vast experience with regulatory arbitrage, they expect will be positioned close to the lowest common denominator. But Treasury Secretary Jack Lew is on the record insisting that international regulatory inconsistencies will not be allowed to foil efforts to impose tough rules. No one should expect the U.S. government to hang back with its reforms just because they do not match up exactly with those across the Atlantic.
So we have plugged the biggest holes in the ship and are engaged now in a broader refurbishment of the decks and engine room. At the same time, areas like IT and cybersecurity are growing risks to the modern economy beyond banking, and “too big to fail” still looms like a monster iceberg as an unresolved issue. Indeed, we would not be devoting so much attention to unweighted leverage ratios if we could solve this problem directly. It is only because “too big” remains a given that we spend so much effort to make sure there is no “fail.”
That said, not all solutions to “too big to fail” are created equal. Because banking reform challenges are both substantively complex and politically resonant, it is an issue ripe for excessive and dysfunctional legislative attention. Populist pressures, which could lead to destabilizing approaches, are privileged in a system that has always empowered parties and courts over executive prerogative. So it is not surprising that two recent legislative initiatives have become an impetus to regulatory reform. They focus on “too big to fail” and raising capital requirements on banks.
Last summer four Senators—Maria Cantwell (D-WA), Angus King (I-ME), John McCain (R-AZ) and Elizabeth Warren (D-MA)—co-sponsored what they called the 21st-century Glass-Steagall Act. The objectives are simple: Banks taking federally insured deposits would be barred from most forms of risky investments, including trading in derivatives, dealing swaps, operating hedge funds and private investment entities. The bill would thus force large banks to split up into independent businesses. A related legislative initiative, called the Terminating Bailouts for Taxpayer Fairness Act, proposed by Senator Sherrod Brown (D-OH) and Representative David Vitter (R-LA), goes after the biggest institutions with capital requirements aimed to prevent any bank from being so large and leveraged that it would require a taxpayer bailout. In their bill, banking institutions with more than $500 billion in assets would be required to hold 15 percent in equity as a minimum leverage ratio. Banks with more than $50 billion in assets would require 8 percent capital. In the academic literature, there are also prominent proposals to drastically raise the level of capital required by banks.
Almost needless to say, bankers do not like either of these bills. Neither is likely to pass, and not just because of Wall Street lobbying clout. There is a big difference between 5 percent and 15 percent capital reserve requirements, and there are plenty of people in Congress who understand this. But such populist proposals help the Fed and the FDIC; wanting to deter meat-axe legislative solutions pushes bankers to embrace regulatory proposals they might otherwise spurn. It is nonetheless striking that recent legislative proposals reflect, almost mirror-like, the proposed regulations of the banking authorities. Restricting the activities of insured institutions and increasing capital are the shared goals of the new approach to avoiding systemic breakdowns.
What Have You Done for Me Lately?
In the United States, Treasury Secretary Lew has made “too big to fail” his own issue, alongside the position of the Fed under the leadership of Chairman Ben Bernanke and current Chairman Janet Yellen. It seems that the threat of a legislative approach to curtailing potential bank bailouts is stirring the Fed and the Obama Administration to tough implementation of rules under consideration or even further rules. Lew publicly asked for legislative forbearance through the end of the calendar year to allow for full implementation of Dodd-Frank requirements. He also highlighted his intention to meet the letter and the spirit of the Volcker rule. In early December, the regulators voted through the Volcker rule, with a 71-page directive to ban banks from betting their capital in risky trades.
For their part, the banks are fighting against all blunt leverage rules. It may well be accurate but it is also clever when they focus, for example, on how leverage would hurt the U.S. Treasury market if the rules are applied to some specialized activities between the Federal Reserve and banks in managing interest rates as suggested by Basel III. But the banks may lose the battle. In early September, for example, Sir John Vickers supported capital requirements of 20 percent, which is double the number stated in his own Independent Commission’s report earlier in the year.
Beyond the Volcker rule and leverage arguments, presently on the table is the devilishly complicated matter of formulating resolution plans—those “living wills” for banks. The global consensus seems to have settled on one of two approaches banks may take to writing a living will. It is dense stuff, even for bankers, but it is worth a short summary. For those that operate as an integrated group (like Goldman and JPMorgan), regulators will use the “single point of entry method” (SPE). For bank holding companies that operate with locally capitalized subsidiaries (like HSBC or Santander), regulators will use the “multiple point of entry method” (MPE). The basic point for the SPE is to organize the groups so that, if they get in trouble, regulators can hit both capital and debt at the holding company level, while a solvent operating subsidiary could continue essential banking functions unharmed. Under the MPE, the approach requires either that the subsidiaries each be sufficiently capitalized or for unharmed subsidiaries to be shielded from locations under resolution. This a big project that is now seriously underway, and it may lead to major structural changes in the banking groups even if no living wills are ever implemented.
It is fair to say, therefore, that we now stand at an important juncture. On the one hand, we could choose a simplified regulatory structure in which banks are lending institutions with heavy capital cushions, but with few other regulatory interventions. That can be so because banks are already well protected against predatory investors because of regulatory barriers, so hits to profitability do not whet the appetites of leveraged investors on the prowl. If you own 5 percent of a bank, you are under regulatory scrutiny; at 25 percent ownership, you are a bank holding company! The alternative and more likely path is to stick with the somewhat increased levels of capital, while continuing to focus on improved and additional prudential supervision and regulation.
Ironically enough, the institutional risks of staying with the present approach may be greater for the Fed than for the banks, though the Fed seems to pay that no mind. More interventionist policies in managing banks to avoid a financial crisis dovetail into monetary policy as the Fed takes a more expansive role in managing credit creation through the banks. The more the Fed favors macroprudential supervision, where it is overseeing the credit creation process across business cycles to manage financial system stability, the greater the risk that the Fed will lose its independence. Macroprudential policy responsibilities force the Fed into macroeconomic and financial stability roles, and that is just asking for political manhandling. Especially at a time when deficits handicap fiscal policy, legislative interest in the Fed’s management of the economy is sure to grow.
The same goes for the European Union and other countries as well. As central banks embrace the macroprudential approach, they break out of the rules-based approach to managing a single target like inflation that protects them from political charges. While we focus on the banks, we should not overlook the impact of feedback loops on the Federal Reserve system itself. Yellen has identified herself strongly with the sorrows of the unemployed. We should expect substantial political interest in the degree to which she balances the needs of the economy for employment-generating growth versus the narrower objectives of traditional monetary policy.
nd then there is always the future to consider. Banking is an industry well disposed to technological disruption because money itself is an abstract concept. It started with shells and beads and grain vouchers before evolving into coin and paper, and it is increasingly becoming plastic- and mobile-based. The mints will not soon shut down, but it seems unlikely that children born today will give their future kids an allowance in paper bills.
That, however, is hardly the big news about tomorrow. Just as MOOCs are challenging the business model of brick and steel universities, and online publishing has all but destroyed the business models of print newspapers, magazines and book-sellers, in finance new models are emerging that offer competitive channels to retail banking. The most intriguing are those seeking to move retail savers and borrowers away from banking into direct relations via the internet. Individuals can already find alternative financing through internet-based crowd-sourcing. Two examples are Prosper and the Lending Club. Reportedly, the web-based Lending Club was on track to originate $2 billion in loans in 2013, with plans to double that in 2014. Its board includes heavyweights like John Mack, former CEO of Morgan Stanley, and Larry Summers, former Secretary of the Treasury.
The goal of these internet-based lenders is, in their own words, “to create a marketplace for loans similar to EBay’s market for goods and services.” While they are small now, the potential for growth should not be underestimated. “The forces of big data as well as the internet are coming together to disrupt lending in a similar way we’ve seen in other industries”, noted an entrepreneur who is building a secondary trading platform to allow lenders to cash in on their investments. Using algorithms for credit evaluation, the peer-to-peer approach is highly competitive because it offers “depositors” higher returns and borrowers lower costs. Lenders are reported to have earned an average annualized return of 9.5 percent from June 2007 through July 31, 2013, which is, relative to commercial bank rates, downright astronomical. Of course, there is no depositor insurance, but solid data is available to all for forecasting likely default rates for the algorithmic determined borrowing population.
Given the profitability of crowd-sourced internet banking, however, the role of the small investor may quickly disappear. Large investors, including banks, are already bundling these loans into pools for money managers, pension funds and sovereigns. Institutional investors are launching new peer-to-peer funds, with reportedly fifty platforms now offering these investments. Prosper has already been sold to former bankers, who were in a broker-dealer business since acquired by Wells Fargo. The bankers brought $20 million in capital from major venture capitalist Sequoia. For Lending Club, a recent reported investment by Google implied enterprise value at more than $1.5 billion, with an IPO expected next year.
What are the policy implications of this sort of innovation? The loans are issued through WebBank, in Utah. Since the loans are securities and not banking assets, the regulation comes from the SEC at this stage. It is burdensome. Every individual loan must be reported separately, and both quarterly and annual reports are required on results. There is also state regulation on retail investors. Although the borrowers come from forty states, investors are permitted in only twenty. Pennsylvania, for example, holds that no one can lend without a license, so the retail lender is shut out. Consumer protection, along with competitive institutional demand, may transform this innovation into simply a modernized version of institutional finance.
These early-stage businesses are worth watching not only for their novelty but as harbingers of the future form of retail banking and lending itself. The regulatory costs to banks of holding capital against loans and the emerging limits on profitability are the push; the technology is the pull. The post-Lehman Brothers regulatory onslaught has diverted many billions of dollars’ worth of funds from potential dividends to fines and settlements with authorities in the United States and the European Union. Large banking institutions both here and abroad are shedding assets and lines of business, and simplifying in favor of less complex businesses with reduced ambitions for stellar equity returns.
As things stand now, banking still depends on two government utilities: the payments system and deposit insurance. The key question, then, is whether new, internet-based institutions fulfill the main functions of a bank without requiring the services that bring it under the aegis of the Fed or other bank regulators. It is hard to imagine a competitive private payments system given the efficiency and safeguards of the present infrastructure. But we can think of crowd-sourced banking as a form of virtual loan securitization without the middleman of a bank’s balance sheet: Investors fund the loans directly through the internet with credit algorithms as their portfolio protection. But that turns the loans into a class of assets of interest to banks and institutional fund managers. There is too much profit to leave this business disintermediated for long. In this new stage, whole loans are being sold, which the banks will buy and leverage. And so the world goes ’round.
Banks today remain a brick-and-mortar business for retail, mortgage lending being a prime example. But with regulation hiving off the profitable securities trading and private investment businesses, and increasing capital requirements for safety and soundness, the branch model intuitively seems too costly. Big brand names in banking will take market advantage of any new models that emerge, even as they shed less profitable baggage. What service will a physical bank provide as the internet age matures? Will your grandchildren one day ask you, “What was a bank?”
And what will be the role of the Fed in all this? The fundamental interest rate in today’s financial world is the Federal funds rate for very short-term interbank borrowing and the discount rate for borrowing from the Fed. Can we imagine banks just borrowing these overnight funds from internet-funded retail sources instead? Well, yes. What then would be the mechanism for the Fed’s setting of interest rates if the gathering and warehousing of deposits is less attached to the Federal Reserve payments system? It seems inevitable that technology will create challenges for what we take for granted as the mechanisms to implement monetary policy.
Most likely, the Fed and other central banks will manage to stay on the curve, if not ahead of it. From a monetary policy perspective, the official sector is using interest rates to affect the cost of credit and, thereby, the pace of growth in the economy. If technology displaces interbank financing with a new mode of funding, the Fed will simply move its charges to a new instrument, perhaps web-based; but credit availability will still be subject to stimulus or restraint. The regulatory fence that keeps banks within the circle is just the means to implement macroprudential policies for growth and financial stability. The means may change but the goals need not. Alas, we are so busy trying, with mixed success, to prevent another Great Recession that hardly anyone is thinking about this onrushing future. “What was a bank?” is a question we may face sooner than we think.