The Banking Revolution

...Where would the foreigners' investments go...

...It is now widely known that almost $5.5 billion or 16.7 percent of Continental's total commercial and industrial loans were oil and gas loans, and that about $1 billion of those loans were originally made by a small shopping center bank, Penn Square National Bank, of Oklahoma City, which had grown in five years from a $30 million to a $500 million bank thanks to lending practices that could have been inspired by the Marx Brothers...

...In both cases they are buying a corporate debt with a view to reselling it...

...Nevertheless he became convinced that no law can long prevent an institutional landslide brought into motion by radical economic sociological, and technological change...

...Is there really any difference between permitting banks to underwrite corporate bonds, which they are not permitted to do, and permitting them to sell pieces of their large loans to smaller banks, often at a lower interest rate, something they are permitted to do and are in fact doing more and more...

...This gratuity was discovered by Continental's auditors in December 1981...

...The bill's major concession to the counterrevolution was outlawing non-bank banks...

...The Continental Illinois disaster came at a time of revolution in the banking industry during which the relationship between banks and the public changed irrevocably...

...It might be better to have dubious securities in the portCongress should bow to the inevitable, if not common sense: Let bank-holding companies go into whatever business they please...

...And knowing that they cannot expand indefinitely might do wonders for the sobriety of a calling whose hallmark used to be sobriety...

...Securities firms like Merrill Lynch established money market mutual funds through which small savers could finally benefit from high interest rates...

...and they did have them all over the country...

...The Senate Banking Committee's hearing record on its last banking reform bill alone is 8,060 pages long...

...The Comptroller noted that "there may be some referral to customer/client from brokers to advisers and vice versa...

...The lesson of Continental Illinois is that banking disasters are caused by bad bankers, not by a short supply of laws and regulations...

...folios of individual speculators than among the assets of small country banks...

...Trust Corp., to permit its Palm Beach, Florida affiliate to maintain checking accounts and to make consumer loans in Florida...

...Let us remember that in the late fifties the Fed permitted a maximum rate of 3 percent a year on time deposits of six months or more and of 1 percent (one...

...Other states either have adopted, or are considering, regional legislation that allows reciprocal entry only to state banks within a defined region, like New England...

...Virtually all public issues are spoken for by buyers before the date of issuance so that the risk of the leading and largest issuers, the syndicate managers, is close to zero...

...Since then other banks have acquired or established brokerage subsidiaries...

...Today Pru-dential-Bache, E.F...

...By dint of heroic labors Senator Garn succeeded in persuading the Senate to adopt a weakened version of his deregulation bill that did not include insurance, real estate, and mutual funds...

...Not that Congress had been inactive during the preceding years...

...There matters rested comfortably until a few years ago...

...As for other investments, the truth is that there are no greener pastures, as proved by the continuing strength of the dollar despite the huge balance of trade deficits and falling interest rates...

...On that road too Citicorp has been in the vanguard...

...In short, if Congress should decide that banking should be more rather than less regulated, the reimposition of interest ceilings on deposits (including certificates of deposit) might well be the best way to go...

...Congress and the Banking Revolution The threatened blanketing of the country by nationwide networks of non-bank bank subsidiaries of giant banks finally roused Congress to try to do something definitive...

...Short-term interest rates, moreover, are not made in heaven or by Adam Smith's unseen hand...

...It is less widely known that John R. Lytle, the loan officer primarily respon'Dutton, $22.50...

...By contrast, Senator Garn during the same period pushed a bank reform bill that would have legitimized most of the status quo and expanded the business opportunities of banks further...

...It might be noted that the international financial crisis of 1982-83 took the form it did, with the banks at risk, only because the public was protected by Glass-Steagall...

...would have placed other new prohibitions on state banks...

...The banks' trust departments have always been in the business' of giving investment advice...

...In the end the lobbying of the diverse pressure groups-the securities industry, the banks, the insurance industry, and the mutual fund industry-deadlocked the legislation in Congress...

...A change of policy by the Fed, and perhaps even a careful look at the compatibility with the antitrust laws of the current system of setting the prime rate, might do wonders...

...And Congress could put ceilings on all interest rates, not only on those that had been under ceilings before 1980...

...Simply write a check or charge purchases on your VISA card-and a loan is automatically made against the marginal securities in your brokerage account...

...Nor is this all: Dean Witter's parent Sears Roebuck & Co...

...Moreover, high interest rates had apparently come to stay...

...As we have seen in the case of Continental Illinois, the top management of a bank blindly pursuing mega-growth is the one most likely to lose track of extravaganzas in its backyard...

...also owns Cold-well Banker, a nationwide real estate broker, Allstate Savings & Loan, a California thrift institution, and Allstate Insurance Company...

...And you decide when and how much to repay...

...In the interim Lytle had saddled Continental with several hundred million dollars more of Penn Square loans...

...Moreover, the same supposed conflict of interest exists when trust departments of banks buy or sell securities of their banking customers...

...Once the initial reluctance of non-banks to compete with banks had been overcome, the hallowed walls of separation crumbled quickly...

...The notion that without exchange controls capital in huge amounts (with the exception of short-term money) would quickly leave the dollar for greener pastures abroad, if interest rates were kept low by law and regulation, is questionable...

...The Banking Revolution The banking revolution is the first against any institutional framework bequeathed by the New Deal...

...The printed records of all that activity could have sunk Noah's Ark...

...For instance, it would have permitted banks to go into insurance, real estate, mutual funds, and the underwriting of mortgage-backed securities...

...Zaccaro and Mrs...

...Franz M. Oppenheimer THE BANKING REVOLUTION As banking outgrows the New Deal, Congress has to face the future...

...Banks did not emphasize their permitted but conceivably extracurricular activities, nor did non-banks try to go into banking...

...What Should Be Done...

...Since new legislation adopted in 1980 gave federal savings and loan thrift institutions, like those acquired by Citicorp, the power of offering checking accounts to businesses and of making loans for commercial purposes, it seems obvious that the great congressional debates on maintaining the one state Carrier are becoming a trifle academic.2 The second way to cross state lines was provided by new legislation in the states, where lobbying by banks has been far more successful than on the Hill...

...Hence a bank that limits itself to offering checking accounts and consumer financing is not subject to the strictures of the Bank Holding Company Act, and thus can be owned by anybody and go anywhere...

...Like the invention of the wheel, the recognition of the potential of a nonbank bank was simple: All that was needed was a careful reading of the Bank Holding Company Act's definition of a bank under which a bank is an institution which takes demand deposits (checking accounts) and makes commercial loans, as opposed to loans to individuals for the financing of cars, houses, washing machines, vacations, and similar non-commercial objectives...

...The Japanese control interest rates and their economy has been exemplary nevertheless...

...real troubles in 1974 . . . [and] that without the certainty of government help . . . [Citicorp] would have unraveled in the late 1970s, when its unanticipated $250-miliion dollar loss in its consumer ventures became more or less public knowledge, or in the early 1980s, when its ludicrous overexposure in Brazil (a country that had accounted for up to a tenth of its alleged profits . . .) became a subject of cocktail-party conversation...

...Second, Congress could address the issue of bigness...

...While it is impossible to pinpoint one single cause of historical developments, the West's surrender to the extortions of the international oil cartel in 1973 and the five-fold increase of energy prices that followed were probably responsible for bringing the halcyon days of tranquil American banking to an end...

...Since brokerage firms and investment bankers had jumped over the wall that supposedly protected the monopoly of banks, the banks thought not unreasonably that they should be allowed to jump over the wall in the opposite direction...

...Indeed more than ten years ago the Bank of America had more employees in New York than in San Francisco, where its head office is located...

...The most dramatic event in this development was the acquisition of the largest American discount brokerage firm, Charles Schwab & Co., by Bank of America which was approved by the Federal Reserve Board in 1983 after elaborate hearings...

...None of our legislators who have debated endlessly the narrow, technical issue of whether banks should be allowed to underwrite and sell municipal revenue bonds as well as ordinary municipal bonds, which they are now allowed to do, seems to be concerned with the major inconsistencies in the arguments for the strict separation of commercial and investment banking...

...In the jargon of the trade, banks sought "product diversification" and "geographical diversification...

...That conflict makes Senator Gam's success in shepherding his reform bill through the Senate particularly admirable...

...Congress should bow to the inevitable, if not to common sense: Let bank-holding companies go into whatever business they please...

...and by late November 1984 there were approximately 300 applications to establish nonbank banks pending before the Comptroller of the Currency, who despite pressure from Congress has already approved a number of these limited-service institutions...

...We know now that in the early seventies Continental's big Chicago competitor, First National Bank of Chicago, was in a similarly shaky condition, and Martin Mayer tells us in his book The Money Bazaars' that "Chase and Citibank had Franz M. Oppenheimer is a Washington lawyer who represents European banks...

...The issue is on its way to the Supreme Court...

...The absence of stable deposit account customers-such as the neighborhood shoe store and the dentist down the street-which forced Continental to borrow money at high rates from foreign institutional investors, did the rest...

...If there were a conflict of interest, it would be the same at home and abroad...

...Moreover, the cash paid into money market mutual funds was not subject to the reserve requirements of the Federal Reserve System, which obligate banks to keep a fixed percentage of all deposits at a Federal Reserve Bank interest free...

...When the demand for a more just return on sayings became no longer negligible, a demand to which the banks were by law prevented from responding, the securities industry business with their stockbroker and their real estate broker, buy mortgage-backed federally insured paper from Coldwell Banker, insurance from Allstate Insurance, and various government-insured Bank Certificates of Deposit from Dean Witter...

...on deposits of less than ninety days...

...According to the dashing loan officer, his superiors seemed "distressed" by this discovery...

...Today there must be more...

...But does it really protect the public if big banks sell portions of dubious loans to smaller banks...

...In December 1983 the American Banker, the daily trade paper on banking, reported that more than 700 banks offered brokerage...

...While it is not true, as one can sometimes hear, that this money has flowed out of the American banking system-U.S...

...One of the more ominous developments...

...Congress should control interest rates...

...Instead of being in individual accounts on which the banks have to pay little or no interest, money has come back into corporate accounts on which the banks, by way of Certificates of Deposit or repurchase agreements, must pay plenty...

...There's no application-no red tape...

...And all this was happening when the big banks' large profits shown on foreign lending proved increasingly fictitious, as debtor countries became unable to service their foreign loans unless they could borrow new money from their creditors...

...subject matter-widely but wrongly perceived as abstruse-make it difficult for many legislators to take a strong stand, for whichever way they go they will offend some powerful pressure group without winning any friends at large...

...The separation of investment banking from commercial banking, for instance, is more conceptual than substantive...

...and would have outlawed nonbank banks...

...No laws or regulations could have prevented the fall of the Continental Illinois National Bank...

...In a free society pressures built up by such dissatisfactions shape the law and institutions...

...True, the principal argument advanced for the separation of underwriting and commercial lending, the inevitability of conflicts of interest, may be less applicable when the selling is limited to the banking fraternity...

...Brandeis's prophetic wisdom on the curse of bigness applies to banks...

...Now the difference between the return on savings to the rich, who could buy Treasury bills and other short-term securities in large denominations, and the non-rich, who could invest their mite only in low-yielding savings accounts, became unacceptable...

...And always keep a-hold of Nurse For fear of finding something worse -Hilaire Belloc The Lesson of Continental Illinois Like necessity, stupidity and wickedness know no law...

...The reaction to this approval was dramatic: About a month later 230 applications to establish nonbank banks had been 2As we go to press, word comes that Citicorp has acquired access to the Cirrus automated teller network, through which customers can obtain cash from 6,500 teller machines in 42 states...

...The most recent development in the breakdown of the walls between banks The lesson of Continental Illinois is that banking disasters are caused by bad bankers, not by a short supply of laws and regulations...

...The facts are that "the certainty of government help" did not prevent Continental Illinois Bank from hemorrhaging, and there was not enough talk to create runs on Citicorp, Chase, or First National Bank of Chicago...

...Under existing law they cannot underwrite corporate securities, but since the law permits banks to buy and sell corporate securities on behalf of their customers, there seemed to be no legal barrier to entering the stock brokerage business in a big way...

...Nor are high short-term interest rates produced by federal deficits, all current folk wisdom to the contrary notwithstanding...

...Unlike small and medium depositors, institutional investors have their ears to the wind, and withdraw their deposits from a bank the moment that bank's name is mentioned by the rumor mills...

...A return to the level of interest rates of the thirties, forties, and fifties would do more to calm our money men than any new legal prohibitions currently under debate...

...The National Bank Act of 1933, known as the Glass-Steagall Act, separates investment banks, engaged largely in the issue and underwriting of publicly offered securities, from commercial banks, primarily engaged in making loans and maintaining checking accounts...

...The bill would have undone virtually everything that has happened in the last four years: It would have prohibited discount brokerage, and the giving of investment advice by banks...

...This new opportunity has produced nationwide banking on a large scale...

...Need extra cash...

...Banks scrambled into greener pastures primarily because of skyrocketing interest rates...

...The call was addressed to Congress, but in the absence of any enthusiasm for quick - action on banking reform there, new profitable activities had to be found by exploiting the interstices of existing federal law...

...To hypothesize, as some do, that Continental's collapse was the result of that revolution or of underregulation is wrong...

...It takes the theatrics of a Penn Square crash and tales of Penn Square executives drinking champagne out of cowboy boots to cause real talk and runs on a bank...

...Now, your balances can be earning income with Dean Witter's new Active Assets Account for Businesses, Non-Profit Organizations and Institutions...

...What were the real banks to do to cope with all these interlopers...

...And young bank officers called on desirable customers everywhere to offer credits to them...

...When Penn Square met its natural fate on July 5,1982, Continental had some one billion dollars in bad loans from that source alone...

...The same slump in the oil and gas industries that had hastened the demise of Penn Square affected Continental's other oil and gas loans...

...The Federal Reserve Board has made it clear that it was opposed to the proliferation of nonbank banks, but after a court battle the Fed last March approved an application of a New York bank, the U.S...

...from the banks' point of view," writes Martin Mayer, "is the effort by Dean Witter to win the accounts of small businesses and professional offices...

...And he quotes a Dean Witter advertisement: "Ordinarily as a small business, you cannot earn interest on balances in checking accounts...

...But what of the underwriting and selling of securities abroad...

...In reality, however, that limitation is little more than a fiction...

...It was always morally refreshing to hear his intelligent, disinterested voice of reason and integrity among the endless self-seeking and repetitious incantations of the hired guns...

...Citicorp's expansion has been the most conspicuous: Citicorp has acquired a savings and loan institution in California with 19 state-wide offices, another one in Florida with 34 state-wide offices, and a third in Illinois with 61 state-wide offices...

...Foreign markets had become pretty theoretical when the Glass-Steagall Act was passed at the end of the great Depression in 1933...

...Again, it is impossible to say whether the inflation and the high interest rates of the seventies were solely caused by the oil cartel, but the increase in oil prices was certainly a necessary even if not a sufficient cause...

...New York and Maine now permit state banks from all states to enter on a reciprocal basis...

...The vigor of that lobbying and the absence of any general interest in the In arguing for maintaining the separation between underwriting and making loans, Martin Mayer says that in the twenties, when investment and commercial banking were still under one roof, the banks dumped Latin American bonds out of their investment portfolios into the hands of their unsuspecting customers "when the banks found out the paper was no good...

...dollars can leave that system only by expatriation or storage under a mattress-the money flowing back into the banks from the deposits of money market funds, or from the institutions whose securities the funds bought, does not bring the same profits...

...Chairman Fernand St...

...Moreover, banks could engage in all investment banking activities abroad, including underwriting, through wholly-owned foreign subsidiaries (Edge Act Corporations...

...Hence Sears could place "financial service centers" in its stores, 130 of them by late 1983, where its customers can do and non-banks was the invention of the so called "nonbank bank" by Gulf Western in 1980...

...In an attempt to give the impression that at least some taboos from the thirties are being honored, the Federal Reserve Board has limited its regulatory approval of brokerage by banks to discount brokerage, which does not include giving investment advice as part of brokerage services...

...Lower American interest rates would lead to lower interest rates in countries competing for short-term funds, so it is doubtful whether even short-term money would depart in significant amounts...

...This was the beginning of the banking revolution, for the banks now had non-bank competitors which could in fact accept deposits and permit the transfer of depositors' money by check and yet were not subject to banking law...

...They debated from December until May about what should be done with him and then decided to punish but not to fire him...

...Ferraro...

...But a corporate treasurer could shift funds to, and withdraw funds from, his company's account in New York by telex or telephone...

...Before becoming a legislator Senator Garn was an insurance agent in Utah, and therefore almost predestined to fight the intrusion of giant banks into Utah and the insurance business...

...Senator Jake Gam, the chairman of the Senate Banking Committee, said about his colleague's bill: "His legislation wants to turn the banking industry back to the 1800s...

...it had lifted interest ceilings, permitted the acquisition of failing depository institutions by out-of-state banks, enlarged the permissible scope of lending by savings and loan institutions, and made numerous other technical amendments of the banking laws...

...and let any respectable company, be it in the securities or in the sausage business, own banks...

...Under new federal legislation, adopted in 1982, banks are allowed to acquire failing out-of-state depository institutions, including savings and loan companies...

...Moreover, in March 1983 the Comptroller of Currency authorized the National Bank of Austin, Texas, to establish a subsidiary to engage in discount brokerage and another to give investment advice...

...found a way of meeting the demand...

...For the latter Dean Witter is making a secondary market so that the investor can sell them back before their maturity...

...The banks, particularly the largest banks, also made new efforts to expand across state lines...

...After what the Wall Street Journal called "a decade of turmoil in the financial services industry," the banking revolution seemed to be sweeping away the last remnants of the banking system left us by the New Deal...

...filed with the Comptroller of the Currency...

...High interest rates in turn brought about a change in the psychology of individuals with cash...

...The invitation extended to states by the Bank Holding Company Act to permit the entry of out-of-state banks by specific language in state banking laws, an invitation ignored for decades, was finally accepted...

...As Martin Mayer says, it had "not been hard to make a buck in banking...

...Even as long as fifteen years ago, however, and perhaps earlier, the biggest American banks were busy all over the country...

...Perhaps-but there was less rather than more public knowledge then, and there are few cocktail parties where any banks become a subject of conversation...

...The supposed "Chinese wall" between trust and banking departments must of necessity be almost as porous as the wall between the business of Mr...

...It would even have further legitimized certain types of nonbank banks...

...Restrictions on the products and services banks may offer were more effective...

...The banks' answer was a plaintive call for "a level playing field...

...would have excluded any company affiliated with a deposit-taking institution from the securities business...

...would have included state banks that are not members of the Federal Reserve System in the National Bank Act's ban on affiliating with investment banks...

...The third principal way of breaking through state barriers, as it was to break the barriers between banking and other business, has been to establish nonbank banks...

...Nevertheless, there were important areas of non-banking left open for banks: For instance, in the securities business, purportedly one of the principal forbidden areas, banks could underwrite federal and local government bonds, engage in the private placement of corporate securities (a method of distribution that has gained greatly in comparison with underwriting for public issues since the 1920s), and place orders for' the buying and selling of securities on behalf of their customers, usually through their trust departments...

...They had been content with the low interest ceilings that federal law had imposed on savings accounts until the arrival of double-digit interest payments...

...The first securities firm to acquire such a nonbank bank was the mutual fund management firm Dreyfus Funds, and the first brokerage firm was Shear-son/American Express...

...Germain of the House Banking Committee, who is convinced of the essential wisdom of the New Deal's banking ideology, introduced a bill last summer designed to undo the revolution...

...Billions had been drawn out of their savings and checking accounts by money management funds...

...Since such laws are designed to exclude New York banks, they have been attacked in the courts, thus far without success...

...But the bill did give its benediction to reciprocal regional banking, i.e., permitting neighboring states to allow interstate banking among themselves...

...The other principal argument advanced against the combination of commercial and investment banking, the supposedly greater risk of underwriting public offering of bonds and stock in comparison to commercial lending, has become unpersuasive...

...But Congress did not enact any comprehensive banking reform legislation that would either undo the revolution or give it a tidy federal framework...

...Nor did anything in the law prevent banks from having sales offices, known as loan production offices, wherever they wished...

...let banks go wherever they please...

...Hutton, Fidelity Financial Services (another mutual fund manager and broker), Parker Pen, J.C...

...Those interest rates are made by the Federal Reserve Board, and in apparent concert by a few giant banks that set the prime rate...

...Penney, and many others own such banks...

...Nevertheless, I wonder whether even he addressed the right issues...

...Without the crash of Penn Square, however, the rumor mills would have left Continental untouched...

...He became equally convinced that it is the duty of Congress to see to it that the public interest, enacted into law, guides and shapes such inevitable changes...

...and the greater receptivity of state legislatures...

...Today, however, the Eurodollar bond market is second only to the New York market, and I can see no sense in permitting the Morgan Bank to underwrite and sell bonds of its large American corporate customers in Europe, but not permitting it to do the same at home...

...Restrictions, I believe, should be explored in two entirely different directions...

...True, a businessman in San Francisco could not find a local branch of New York's Morgan Guaranty where he could stand in line to deposit a check or withdraw cash from his account...

...it is not the other way around...

...sible for Continental Illinois' purchases of worthless loans from Penn Square, had received from Penn Square a personal loan of $585,000...

...In any event, the prime rate was 5.75 percent at the end of 1972 and had risen to 11.5 percent by May 1974...

...The Bank Holding Company Act of 1956 prohibits bank holding companies from operating banks in more than one state, unless a state statute specifically invites them in, and from conducting commercial and industrial business unrelated to banking...

...These restrictions on the geographical reach and the business mix of banks seemed as solidly anchored in American life as driving on the right-hand side of the street...

...let banks go wherever they please...

...Certainly the risk that any bank would take in that business today seems insignificant when compared with the risk of lending...

...Congress also commissioned studies, requested reports from the federal agencies, held innumerable hearings, and filled its hoppers with scores of banking bills...

...In addition, they permitted investors to-withdraw cash from the funds by check...