Under the original National Banking Act, real estate loans were completely prohibited for national banks. Of course, we would expect history to bring changes from the ideas of an act passed nearly 150 years ago, but over the last few decades the American banking system has gone to the opposite extreme.
Starting in 1974, it developed a truly remarkable structural concentration in real estate risk.
Without considering this long-term trend, we cannot understand the Double Bubble in residential and commercial real estate credit, the inevitable Double Bust, the consequent new round of hundreds of bank failures or the insolvency of the FDIC.
A simultaneous long-term trend is the disappearing role of demand deposits as a funding source for commercial banks. These deposits were formerly considered (for example, by the old bankers who instructed me in the business) to be the essence of banking.
Banks used to be legally and intellectually defined as institutions that take demand deposits and make commercial loans. Academic discussions of "why banks are different" from other businesses still focus on their role in providing checkable deposits for the operation of the payments system.
But checkable or demand deposits have become an almost trivial part of the funding of the banking assets. The accompanying graph displays this striking long-term trend. In 1950, checkable deposits were about 65% of the total assets of all U.S. commercial banks. (At that point they were also about 200% of total loans.) By 1969, when I was a bank trainee, they were still 39% of banking assets. By 2008 they were a mere 5%.
What then is special or different about the rest of bank funding? Only that most of it is guaranteed by the government.
How about the other half of that old definition of what banks are: that they make loans to finance commerce, or commercial loans? This has been replaced by the fact that most bank loans are now real estate loans.
The graph also shows real estate loans as a percent of total loans for all U.S. commercial banks from 1946 to 2008. This is an evolution worthy of serious study.
It is immediately apparent that this line has two parts. For three decades after the end of the Second World War, it is flat at about 25%. Then, starting in 1974, it heads inexorably up, pausing temporarily after the last real estate bust of the early 1990s before resuming its climb. With the Double Bubble well inflated in 2006, over 55% of the total loans of the entire commercial banking system were real estate loans.
What happened in the mid-1970s to set off this structural shift in the banking system? Arguably it was the loss by banks of much of their corporate banking business to the commercial paper and bond markets. What allowed banks to continue to expand real estate risk after the early 1990s bust? Among other things, government guarantees delivered through the FDIC and the Federal Home Loan banks.
An important addition is that if we look inside the overall numbers, at the group of banks whose assets are less than $1 billion, we find the risk concentration is even more intense. This group represents 90% of all banks. By 2008, 74% of their total loans were real estate loans.
Nor is the real estate concentration of the banking system's risk limited to its loans. The other principal category of banking assets, securities, also has come to display heavy real estate risk exposure.
By 2006, 74% of the total securities owned by U.S. commercial banks were either mortgage-backed securities or the debt of housing GSEs. In other words, the banks' investments displayed the same fundamental risk as their loans, heavily encouraged through government sponsorship of real estate lending.
It is a banking adage that real estate developers will borrow as much as somebody is willing to lend them.
This is a constant temptation to banks that want to increase their lending and their short-term profits. All banking experience, moreover, testifies to the vicissitudes and cyclical crises of real estate credit, an experience doubtless on the minds of the fathers of the National Banking Act in 1863. Needless to say, here we are again.
But focus on the huge difference of entering a real estate bust with 25% of your loans in real estate, the postwar level, versus entering one with 55% of your loans in real estate, let alone 74% of your loans for smaller banks! Add to this having 74% of your investment securities in real estate.
It couldn't possibly have turned out to be pretty, and of course it hasn't.
The old definition of banks, "take demand deposits and make commercial loans," has been changed in practice to a new one: "borrow money guaranteed by the government and make real estate loans." The implications of this structural shift for systemic financial risk have yet to be worked out.