Mark W Olson: Are banks still special?
Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve
System, at the Annual Washington Conference of the Institute of International Bankers,
Washington, DC, 13 March 2006.
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Thank you for inviting me to speak to you today. Over the past twenty years, I have attended many of
these Institute of International Bankers (IIB) spring conferences in Washington, D.C., either as a
speaker or a participant. These meetings continue to address interesting and pertinent issues. The
consistently larger number of attendees at a meeting here in Washington, as opposed to a meeting in
one of the more dynamic international financial centers like New York or Los Angeles, reflects this
group's clear recognition that public policy has a direct impact on the viability of your respective
institutions. Appropriately, most of the topics presented over these two days cover legislative and
regulatory issues intermixed with critical strategic issues. For my presentation, I will revisit a topic
initially raised twenty-four years ago by a former president of the New York Federal Reserve Bank, E.
Gerald Corrigan. In 1982, Jerry Corrigan, then the president of the Minneapolis Federal Reserve Bank,
wrote an essay entitled "Are Banks Special?" for the Bank's annual report. Today I would like to revisit
the issue and ponder the question "Are Banks Still Special?"
I realize that some of you may be wondering why a focus on the specialness of the domestic U.S.
banking industry would be an appropriate topic at a meeting of foreign bank representatives. There
are several reasons why the subject is relevant to this group. First, U.S. laws and regulations for
foreign banks adhere to the fundamental principle of national treatment. That is, our regulations allow
foreign banks to have the same range of product authority as domestic banks. Therefore, any change
in policy that affects domestic banks will also potentially affect the range of products foreign banks
may offer. Another reason why the issue is likely to be of interest to this audience is that, in any
discussion of product authority or regulatory structure, the experiences of other nations are often used
as examples. These examples are often presented as policies or practices to be avoided or emulated.
But the accuracy of the facts presented to support or oppose other countries' experiences is not
always clear. At times, these "facts" may be undocumented generalities or even wild speculation.
Let me return to Corrigan's essay. In 1982, the banking industry was facing an identity crisis unlike any
it had faced since the Depression era fifty years earlier. Within a period of a few months in the
mid1930s, Congress (1) required the separation of banking from many securities functions by passing the
Glass-Steagall Act, (2) provided protection for bank depositors by passing the Federal Deposit
Insurance Act, and (3) authorized the creation of a dedicated home mortgage lender by passing the
Home Owners' Loan Act. Through these laws, Congress established the legal framework that clearly
delineated the competitive relationship for the securities, banking, and thrift industries for close to fifty
years. This delineation extended to the marketplace for the banking and securities industries. During
this period, there were few issues of controversy between banks and securities firms, the most notable
exception being the narrowly focused but heated disagreement as to whether banks should be
allowed to underwrite revenue bonds. The Glass-Steagall Act specifically authorized banks to
underwrite general obligation bonds, but the act was silent on the issue of revenue bonds. The
banking industry viewed that as an oversight; the securities industry viewed it as a purposeful
exclusion. This debate went unresolved until 1999, when the Gramm-Leach-Bliley Act specifically
authorized revenue bond underwriting by banks. In contrast to the relative peace between banks and
securities firms, the competition for deposits between banks and thrifts was quite strong and
intensified with the imposition of Regulation Q. Not only did Regulation Q establish ceilings on interest
rates for both passbook savings accounts and certificates of deposit (CDs), the regulation gave thrifts
an interest rate advantage of initially 50, then 25, basis points for each of their interest-bearing
products. The intense marketplace competition between banks and thrifts was matched by the level of
competition in the halls of Congress. Bankers aggressively worked to eliminate that quarter-point rate
differential, while thrifts worked equally hard to preserve it.
Such widespread competition was nonexistent between the securities and banking industries. From
the 1930s to the late 1970s, there seemed to be a clear distinction between investment and savings or
at least between investment dollars and savings dollars. Savings dollars were held in passbook
accounts or CDs, and were insured up to certain limits by Federal Deposit Insurance Corporation
(FDIC) or Federal Savings and Loan Insurance Corporation (FSLIC) insurance. Investment dollars
were in equities or bonds. Banks and thrifts waged a turf war against each other, but neither industry
aimed its marketing guns or lobbying efforts at the securities industry. Then along came money market
mutual funds, or money funds.
High interest rates during the late 1970s and early 1980s had a stunning effect on the flow of deposits
into banks and thrifts. Money fund shares issued by investment firms offered market interest rates and
a high level of liquidity, through either immediate withdrawal or the ability to effect transactions by
using payable-through drafts. By contrast, Regulation Q mandated low interest rates on passbook
accounts, specific term restrictions on CDs, and significant penalties for early withdrawal. Money funds
offered rates that were at times double the rates on passbook accounts. The banking industry had no
products to counter the market appeal. Even though money funds shares are not federally insured,
billions of dollars flowed into the accounts. In 1981 alone, $109 billion flowed into money funds. After a
tepid and wholly unsuccessful effort by bankers to restrict the growth of money funds, the banking
industry began considering a different response. Now that the securities industry had successfully
breached the separation between banking and savings by allowing consumers to invest in money
funds, the banking industry was forced to examine its fundamental marketplace role. During that
period, I was the vice chairman, then the chairman, of the Governmental Relations Committee of the
American Bankers Association. At meetings held between 1980 and 1982, as many as 400 bankers
representing institutions of all sizes and markets gathered to consider an industry response.
Congress's response to the growth of money funds was to pass the Monetary Control Act of 1980 and
the Garn-St Germain Act of 1982. Taken together, these laws, along with other provisions, eliminated
many of the rate and term restrictions on banks' and thrifts' deposit taking and allowed both types of
institutions to offer products that could match the rate and liquidity provisions of money funds. But it
was clear to many bankers that a lasting response to marketplace changes would require more than
just the removal of Regulation Q. Bankers were seeking answers to such basic questions as "What is
a bank?" and "What is the public purpose of banking?" Jerry Corrigan's essay proved to be a beacon
of rationality in that discussion.
Are banks special?
Corrigan identified three characteristics that made banks special:
- Banks and only banks offered transaction accounts. That is, "they incurred liabilities payable
on demand at par and are readily transferable by the owner to third parties." That transaction
account authority helped "to insure that financial disruptions do not spread." Backed also by
deposit insurance and access to the discount window, banks "reinforced public confidence
that is essential to a healthy economy."
- Corrigan's second criterion identified banks as critical backup sources of liquidity. In fact his
essay stated that "banks are the primary source of liquidity for all other classes and sizes of
institutions, both financial and nonfinancial."
- The third characteristic Corrigan identified is that banks "are the transmission belt for
monetary policy. That role combined with operating the payments mechanism permit the highly
efficient financial markets to function and effect the orderly end of day settlement."
Corrigan went on to address the question "what is a bank," a question that had been complicated by
different definitions in different laws. The Federal Deposit Insurance Act defined "bank" differently than
the Bank Holding Company Act did, a distinction that allowed commercial entities to own FDIC-insured
banks by narrowing their product offerings to meet the BHC Act test. (The Competitive Equality
Banking Act reconciled these definitions in 1987.) If banks are special, Corrigan stated, limitations on
what services and lines of business banks could offer were justified. Further, the services of
businesses that are allowed to be owners of banks should reflect in a nearly symmetric way, the
services banks are allowed to offer. Corrigan had made a remarkably prescient observation, as the
Gramm-Leach-Bliley Act that would be passed seventeen years later essentially adopted that last
criterion in determining what types of corporations could own banks, and what activities could be
conducted in those corporations. Between the publication of Corrigan's essay and passage of the
Gramm-Leach-Bliley Act, market forces, supported by either regulatory interpretation or court
challenges, continued to blur the lines between the banking, securities, and insurance industries. As
capital markets expanded, mutual funds put pressure on bank deposits. In Europe, foreign bank
successes in securities activities suggested that banks conduct these activities in a safe and sound
manner. But until 1999, there was no legislative response to these basic marketplace changes or to
the broader question of the separation of banking and commerce.
Separation of banking and commerce
The appropriate separation of banking and commerce is a delicate proposition that has both historical
and philosophical underpinnings. The term "separation of banking and commerce" can mean different
things, depending on the perspective of the person using the term. At the time of Corrigan's essay--the
early 1980s--the statutory authority for that separation was largely contained in two laws: the
GlassSteagall Act, which separated commercial banking from certain investment and securities activities,
and the Bank Holding Company Act (with amendments), which narrowly limited the activities of
corporations that were allowed to own banks. When it passed in 1956, the Bank Holding Company Act
was thought to have been in response to one company's aggressive expansion into banking activities.
That company, Transamerica Insurance, had expanded into several western states and concerns
were raised about the resulting concentration of financial resources. Therefore, the ensuing body of
law on the commerce and banking issue concentrated significantly on separating, or was inspired by
desire to separate, banking from securities or banking from insurance. From the time of Corrigan's
essay until passage of Gramm-Leach-Bliley, the banking industry had expanded substantially into both
the securities and insurance agency fields, though significant restrictions still remained.
Much of the industry's expanded securities authority was gained through the Federal Reserve's
approval of securities underwriting for banks, under Section 20 of the Glass-Steagall Act. Under the
Federal Reserve's rule, a bank subsidiary was "not engaged principally" in securities underwriting if at
first 5 percent, then 10 percent, and ultimately 25 percent of its revenue came from underwriting. This
expanded authority allowed many banking organizations, though almost exclusively large banks, to
significantly expand their domestic securities activities. These same powers were extended to foreign
banks operating in the United States.
In insurance, gains for the banking industry were largely the result of court determinations that
annuities could be underwritten and sold by banks. Court determinations also expanded national
banks' ability to market insurance products. Consequently, banks of all sizes have expanded their
involvement in insurance and annuity activities.
By 1999, banks and bank holding companies had gained significant additional product authority in
securities and insurance, areas that had been perceived to be on the other side of the banking and
commerce wall at the time Corrigan wrote his essay. A number of factors persuaded Congress that
federal action was appropriate, and the Gramm-Leach-Bliley Act was passed. Congress had learned
from the securities and insurance experiences of foreign banks, both the high points and the low
points. On the one hand, institutions in some European countries had successfully broadened their
securities and insurance activities. On the other hand, there were lingering questions about whether
some Pacific rim banks were too closely linked to certain commercial enterprises in the region, thus
facilitating the Asian financial crisis of the late 1990s. However, the U.S. banking industry had also
developed improved ways to manage risk, and banking supervision had become more effective. In
addition, the improved analytical capacity offered by new technology, better coordination among
domestic and international bank supervisors, a healthy track record for U.S. banks, and the growth of
consolidated home-country supervision across the world helped U.S. banks and their affiliates to
further expand their commercial activities.
The response of Congress was essentially threefold. First, it moved the separation wall between
banking and commerce to reflect what had already occurred in the marketplace: Gramm-Leach-Bliley
also addressed the broader question of what types of businesses could own or affiliate with banks by
allowing companies to own banking, securities, and insurance entities within a structure known as a
financial holding company. Second, Congress provided a way for banks to gain new-product authority
when the new products were determined to be financial in nature, incidental to banking, or
complimentary to existing banking authority. Third, by clearly separating the federally insured
entity-either banks or thrifts--from the newer and potentially higher-risk new-product authorities,
GrammLeach-Bliley reaffirmed as a matter of public policy that banks continue to be regarded as special. But
the act offers a clear acknowledgment that the separation of banking and commerce is not a bright line
but is instead a negotiated compromise--one that will continue to move as markets change and
products are refined. The guiding consideration in this compromise will be the protection of the federal
deposit insurance fund.
Are banks still special?
Much has changed in the banking landscape since Corrigan wrote his essay twenty-four years ago.
Significant increases in international capital flows among bank and nonbank entities, in addition to a
broad range of specialized financial instruments mean banks can no longer be considered the only
source of transaction accounts. Except for their access to the Federal Reserve discount window,
banks are no longer the dominant provider of liquidity for other financial industries. But banks remain
the key access point to the dominant wholesale payments network, and they still provide federally
insured checking and savings deposits. With the rise of new financial services, products, and
techniques, moreover, banks have expanded their role in providing liquidity in more indirect ways, for
example, through securitization of loans and backup commitments to securitization vehicles and other
capital-markets instruments. Even when banks may not be "special" or unique providers in a particular
market, banks have proven themselves to be formidable competitors and innovators--which only
reinforces banks' importance in the proper functioning of our financial system. In short, the public's
trust and confidence in banking continue to be vital to our financial well-being.
Banks provided considerable credit in the aftermath of the September 11 attacks, when financial flows
were slowed by operational problems. To be sure, banks were able to provide this credit in part
because of the huge injection of liquidity provided by the Federal Reserve. But that is a key role for
banks in a crisis: to obtain funds--through the discount window or from open market operations, if
necessary--and to channel them to those needing funds, based on an assessment of their
creditworthiness. Banks' access to the discount window and the payments system, as well as their
ongoing relationships with customers and their credit-evaluation skills, allow them to play this role.
During a crisis, those banks that play critical roles in the payments system are especially important. As
a result, these banks are expected to be very resilient. Though banks now have a smaller role in
transmitting monetary policy, they still help to transmit policy actions by arbitraging between the
federal funds market and other money markets.
Conclusion
A strong case can be made that banks continue to be special. And because they are special, we, as
regulators, will continue to apply high standards to companies seeking a bank charter. We must also
continue to examine and supervise banks for safety and soundness. Likewise, it appears that
Congress will take a cautious approach when determining what types of companies may own and
affiliate with banks.
But banks must also compete in the marketplace. Consequently, we can expect over time to see
adjustments in both the direct activities of banks and in the line separating banking and commerce.
History is, in some sense, about the drawing, re-evaluation, and re-drawing of lines. As a matter of
public policy, changes will trail rather than lead the marketplace, and any changes must be informed
by a careful study of both the role we want banks to play in our economy and the needs of the
marketplace.