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CHASM: Systemic risk will endure, but 'getting people to intellectually cross that bridge and to accept that hypothesis has been very difficult,' says Gerald Corrigan.
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Are Banks Special? Three Decades On, the Question Endures

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Are U.S. banks just providers of products and services? Or are they a special class of institutions whose extraordinary privileges and central role in the economy entail extra responsibilities and strict limits on the businesses they can enter?

An essay on this question remains as relevant today as when it was it was written more than three decades ago.

Gerald Corrigan, who was then president of the Federal Reserve Bank of Minneapolis, entitled his 1982 article "Are Banks Special?" and answered the question in the affirmative.

Banks are special, argued Corrigan, primarily because they take deposits that are payable on demand, they back up other forms of credit such as commercial paper, and serve as a conduit for monetary policy. These unique functions imply that banks require a unique level of supervision and protection, he suggested.

Much has changed from the rise of complex derivatives to the arrival of mobile technology but the question about banks endures. The swirl of debates over "too big to fail," limits on proprietary trading, restrictions on retailers owning banks, the advent of digital currency and the evolution of the payments market all turn to some extent on the conceptualization of banks.

Corrigan, now 72 and a managing director at Goldman Sachs (GS), wrote the essay in 1982. It resulted from his friendship with former Federal Reserve Chairman Paul Volcker, whom Corrigan had served as a special assistant.

The men were brainstorming one night about the banking system and the pressures banks faced with the U.S. mired in recession and competition at home and abroad intensifying. Billions of dollars flowed out of banks and into investment firms, which had begun to offer money market accounts resembling traditional checking but paying rates significantly higher than banks could legally offer.

"Chairman Volcker brought up the subject of the ongoing implications of all these emerging changes for banks' competitive position, and I remember saying to him that somebody should write an essay on this, and typical Volcker, he responded by saying, 'You're right, why don't you do it?'" Corrigan recalls. "It turned out to be a hell of a lot harder to do than I realized when I set out to do it."

Corrigan went from his post in Minneapolis to the New York Fed, where he served as president for eight years starting in 1985.

The phenomena he and Volcker observed preordained changes in the financial landscape that were to become prominent.

Competition, innovation and deregulation ushered in with the election of Ronald Reagan in 1980 "really became the future of the universe," Corrigan says. "And as a consequence of that, we began to see systemic forces beginning to show their ugly head, not just with banks and the banking system but with the financial system more broadly."

The stock market crash of Oct. 19, 1987 when the Dow Jones industrial average plummeted 23% highlighted one of the special attributes of banks.

"Banks became the lenders of next-to-last resort," Corrigan recalls. "That was one of the reasons that we were able to contain damage of the stock market crash with remarkable success."

But the crash also showed how the world was changing, says Corrigan, who points to two other developments in the 1980s that also underscored that reality. One was the government rescue in 1984 of Continental Illinois National Bank, which had turned to Europe for funding a practice with little precedent at the time. It was the largest bank to fail in U.S. history, a title it held until the collapse of Washington Mutual in 2008.

"All of a sudden we're looking at the imminent failure of one of the largest banks in the U.S. that was funding itself in Europe," recalls Corrigan, who noted that European banks, unlike their American counterparts, distinguished little between traditional banking and activities in the capital markets.

The other change also originated overseas, where the rebuilders of Germany and other countries devastated by World War II had encouraged steelmakers, auto companies and other businesses that survived the conflict to recapitalize banks. That contrasted with the U.S, which had historically separated banking from commerce.

By the mid-1980s, the developments overseas reverberated in America, where, Corrigan notes, policymakers later eased restrictions that had prevented industrial companies from controlling banks a suggestion Corrigan says he thought was "nuts, but it was a very hot issue."

In 1987, the Federal Reserve, over Volcker's objection, permitted bank holding companies to underwrite certain securities. The stipulations by which lawmakers permitted commercial banks to enter the underwriting business including the use of holding companies and subsidiaries, in contrast with European banks that carried on those activities within the same company preserved much of what made banks special, according to Corrigan. Still, he "probably had some reservations about going that far at the time, but that the die was cast."

In December 1987, Corrigan testified before the Senate Banking Committee. Congress had begun to consider a revamp of banking legislation that culminated in the 1999 repeal of the Glass-Steagall Act of 1933, the Depression-era law that separated commercial and investment banking.

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I have one quibble with Mr. Corrigan's understanding of history. The US has not "historically" prohibited commercial companies from owning banks. The US allowed any company to own a bank prior to 1956. During the Great Depression the banking system in Michigan was especially hard hit. Most banks failed and the state was desperate to get banks functioning again so the economy could recover. Like Europe after WWII, the state reached out to industrial companies to help capitalize new banks. GM and Ford both responded. One organized the National Bank of Detroit, the other organized Manufacturers National Bank of Detroit. Those became the leading banks in Michigan until they were acquired in the 1980s and GM and Ford held stakes in those banks until the 1950s.

The BHCA was enacted in 1956 as the Fed was battling to stop Transamerica from acquiring Bank of America. Transamerica already owned several banks throughout the southwest and the Fed said it would gain market dominance if it got BofA. The dispute was initially litigated as an antitrust case and the Fed lost. The Fed then went to Congress to get a new law to stop the acquisition. It selected a sledgehammer banning all affiliations between a bank and any other kind of company. Since then Congress has also enacted the scalpel in the form of laws limiting the percentage of deposits a single bank can hold and requiring deposit taking offices to lend a percentage of deposits in the local community. Thus, the BHCA could be repealed in its entirety and a holding company could still not get a banking monopoly anywhere in the nation.

With the enactment of CEBA in 1987, commercial companies became able to own banks. As a group, the banks organized under that authority have over the past 20+ years been among the best capitalized and most profitable banks in the nation, mostly because they have access to abundant capital through a diversified parent. The principal legacy of the BHCA is a weakened banking system due to severe restrictions on banks' access to capital.
Posted by gsutton | Tuesday, July 02 2013 at 4:16PM ET
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