Are Banks Special? Three Decades On, the Question Endures

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.

Corrigan devoted part of his testimony to "raising big bold red flags about systemic risk issues." Continental's failure, the October 1987 market crash and the push to strip away regulation had alerted him to threats that policymakers perilously disregarded.

"Keep in mind that deregulation was very fashionable in the Reagan administration and into the Bush administration and also in the Clinton administration," Corrigan notes. "It was the fashion of the day for the better part of almost three decades."

"In hindsight we may have gone too far," says Corrigan, who adds that the repeal of Glass-Steagall was part of a much larger picture of technology-driven changes in the speed and complexity of banking and finance.

Between deregulation, the emergence of the derivatives market, the growing complexity of corporate finance and the buildup of debt by the government, businesses and households, something had to give.

"Everybody kind of knew there would be an adjustment but thought it would be orderly," he recalls. "But it was anything but ordinary" when the 2008 financial crisis hit.

Still, Corrigan cautions against tying the financial crisis to the loosening of restrictions on banks.

"That dog simply doesn't hunt," Corrigan says. "I personally may have had some reservations about repealing Glass-Steagall, but I don't think I could make a case that would say the reason we had the crisis was because we got rid of Glass-Steagall. Life is not that simple."

Corrigan remains concerned about systemic risk, which he says will stay a fixture of the financial landscape because of the speed of modern finance and the march of technology. Even after banks satisfy standards for capital and liquidity that significantly exceed measures people regarded as adequate 10 or 15 years ago, the risk will endure, says Corrigan.

"Getting people to intellectually cross that bridge and to accept that hypothesis has been very difficult," he says.

The nature of systemic risk and the warp speed of change "mean that prudential standards for major financial institutions have to be much stronger than in the past," says Corrigan, who feels encouraged that policymakers now discuss standards for capital and liquidity as "a single discipline."

"What makes them a single discipline we know from centuries of history — that when financial institutions get in serious trouble the thing that ultimately does them in is loss of liquidity and funding" says Corrigan, adding that "we've got to have a more efficient system of orderly resolution when, not if, we have to confront one of these large institutions failing in the future."

Strengthening the safety and soundness of the global financial framework presents one of the top challenges for the world, according to Corrigan. "We're not there yet, but real progress is being made," he says.

As for the essay, Corrigan remains amazed that it continues to influence successive generations of students.

At a reception in May at George Washington University, two young women whom Corrigan did not know approached him. "They introduced themselves and told me that for one of their courses at GW law school, 'Are Banks Special?,' vintage 1982, was still one of their required readings," Corrigan recalls. "I never imagined it would still be on anybody's reading list."