The Future of Banking

James L. Pierce teaches economics at the Berkeley campus of the University of California and has worked at the Federal Reserve in Washington.

The Twentieth Century Fund asked him to write this book to try to simplify the issues in the current banking dilemma so that policymakers would understand them and presumably make valid judgments as to how to cure the industry's problems. Further, Mr. Pierce was asked to offer his own solutions to banking's difficulties.

This book succeeds in the first charge by presenting a lucid and unusually preceptive analysis of why banking is in its current state. However, it fails in its second mission since its suggested solutions could cause more harm than good.

Thus the book is more about banking's past rather than, as the title implies, banking's future.

Whither Banks?

The fact that Mr. Pierce, who is clearly knowledgeable about banking, fails to offer viable solutions indicates the intractable nature of the banking industry's problems. His failure raises again the issue of whether in fact the banking industry has a future. Or whether banking will go the way of the railroads - unable to compete with technologically advanced competitors - and destined therefore to limp along for decades as a public problem.

Mr. Pierce believes that the banking industry developed in response to two economic needs:

* The first he defines as a monetary one, whereby bankers protect "money," account for its ownership, and facilitate its use in settling economic transactions. In this original role the banks did not provide a return to the holders of funds since they were really providing a service for which they were entitled to receive compensation.

* In its second role, banks evolved into the most efficient institutions for taking funds from surplus holders (depositors) and providing them to deficit holders (borrowers).

However, in this second function, they often ran into trouble because banks essentially took liquid deposits and converted them into illiquid loans. Thus, whenever depositors lost faith in the economic or financial systems, and demanded their money back en masse, banks could not obtain the funds rapidly enough and devastating collapses occurred.

Yesterday's Solutions

Mr. Pierce indicates that in the 1930s, in response to a particularly devastating failure of the banking system, the United States established a regulatory structure to solve the industry's problems. This structure had a series of basic elements:

* The Federal Reserve was to act as lender of last resort, providing liquidity to banks when the depositors wanted their money.

* The Federal Deposit Insurance Corp. was to insure deposits so that individuals would put their funds back into the banking system, assured that they would be safe.

* Banking was to be insulated from high-risk lending by separating the industry from investment banking and commercial ownership. The industry was supposed to lend money only with great discretion.

* Finally, the profitability of banking was to be ensured by restricting entry of others into the industry. By giving banks a monopoly of sorts in their limited territories, it was felt that banks would generate significant profits and not need government assistance.

Root of Today's Problems

This system worked unusually well until the 1960s, according to Mr. Pierce. At that time, changes in the structures of the money markets and major improvements in technology allowed competition to flood into banking.

The competitors offered financial products that cost less and were more flexible, and thereby effectively challenged the profitability of the banking industry.

Two examples of this were money funds and commercial paper. When Merrill Lynch developed its cash management accounts, it showed that a nonbank could handle the monetary function of a bank more efficiently than a bank could (excess deposits in these accounts were swept into savings certificates automatically).

In addition, Merrill Lynch was willing to pay a high return for demand deposits, while banks offered none.

In the commercial sector, large corporations discovered that massive pools of funds had been created in world markets, and that the technology existed to allow a corporation to access this money. Most surprisingly, by borrowing in the Euromarkets, a corporation could fund itself at a lower cost than even the banks.

Mistakes on Two Fronts

The regulators refused to adjust their actions to the changes occurring in the financial product sector.

Therefore, banks were hindered from developing products that would compete with the new sellers of financial instruments until the competitors were well entrenched in the market.

The banks also made substantial errors in judgment. For one, they began borrowing funds in the international money markets and lending this money where they hoped to get a high return, only to suffer from the high risk associated with these sectors.

With bank profits falling, the government found itself with a severe problem, particularly in the thrift industry. It reacted by placing further restraints on banking, while neglecting the overall problem: the inability of banks to compete effectively in the new environment.

Up to this point, Mr. Pierce's book appears to be right on track. The problems arise when he proposes solutions as to what to do about the current situation.

Mr. Pierce quite rightly acknowledges that the government cannot go back to the old techniques of regulation (which it is trying to do) because the nature of the sale of financial products has profoundly changed. These changes include Euromarkets that are bigger than the domestic money supply, incredibly sophisticated technological improvements, and the existence of well-entrenched nonbank competitors.

Therefore, Mr. Pierce advocates the establishment of a system that would facilitate the two essential functions of banking in this new environment.

The Proposals

To begin with, he proposes monetary service companies be established that receive deposits and lend their funds in short-term, high-quality instruments. These companies would also handle the safekeeping of funds, account for their ownership, and provide methodologies (checking accounts) to see that money was used to facilitate economic transactions.

In addition, Mr. Pierce would create financial service companies that would be free to use their deposits as they choose. Unlike the monetary service companies, the financial companies would not have insured deposits and would be at the mercy of the free market in terms of gathering funds and lending this money.

This approach would neatly solve Congress' problem with the banking industry, since the United States would only be insuring bank deposits that were invested primarily in Treasury bills or high-quality corporate paper.

Problems with the Solutions

Plus, if failures occurred in the financial companies and investors lost their money, it would be a private sector predicament alone. (Mr. Pierce believes that it would be healthy if this happened because it would force depositors to look more closely at where they placed their funds.)

Mr. Pierce's proposed solutions, however, raise some difficulties. First, the system that he envisions would effectively channel available funds to the strongest elements in the economy and there would be no method of providing monies to smaller, riskier entities. In essence, the U.S. economy would be dominated by large corporations.

Second, since there would be no prohibitions against industrial companies owning the two types of companies envisioned, available funds would be concentrated in the hands of a relatively small number of entities.

Moreover, the instability that the present regulatory environment seeks to eliminate would be re-injected into the financial system, since runs on the new financial service companies would have the same impact on the system that runs on banks had more than 50 years ago.

Despite these weaknesses in Mr. Pierce's proposals, his book is well worth reading. It is insightful in its treatment of banking problems, and while it does not answer questions about the banking industry's future, it focuses the reader on all the relevant issues.

Perhaps the most intriguing quote from the book is on page 126: "Banks will continue to experience difficulties because they will have progressively less of economic value to offer."

The book that everyone is waiting for will answer the question: What it is that banking does offer on a proprietary basis for future users of the industry's services?

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