The Institutional Risk Analyst

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Good Banks, Bad Banks...

This essay is part of a longer paper on the US banking system that is part of my research for a future book.

What makes a bank good or bad? In financial terms, a “bad bank” describes an institution that houses problem assets and is being run-off. The bad bank is legally separate from the “good bank,” which is solvent and presumably able to function normally as a going concern. Beyond mere financial factors, however, in the wake of 2008, the idea of bad banks conjures up bleak images of financial contagion and economic dislocation that are universally shared.

Even before 2008, banks as institutions did not enjoy particular popularity in American culture. People seem to love their local banker, but hate banks in general – especially enormous banks

located in big cities. Small banks and credit unions have fiercely loyal followings, but large banks have proportionately larger groups of detractors. This skeptical view of banks, especially larger institutions, is hardly new.

Going back to the founding of the American republic, banks were seen as speculators and parasites, members of the business elite of large cities who preyed upon small farmers and working people. President John Adams, who believed that the US should have a single public bank to serve the nation, in 1813 damned private banking as a giant swindle, a "sacrifice of public and private interest to a few aristocratical friends and favorites."

President Andrew Jackson’s veto of the Second Bank of the United States in 1832 was a blow against a privately owned “central bank.” More than defending financial probity, Jackson objected to the elitism and the power of the larger banks of that time. “Nothing galvanized American political conflict more than banking, currency, and finance,” wrote Daniel Feller of the early days of the US. “In the republic's first half-century, no subject, save foreign relations and war, gave greater vexation to American statesmen or aroused more heated public debate.”

From 1832 through the creation of the Federal Reserve System in 1913, the US did not have a “central” bank, but it did have thousands of private banking institutions that made loans and issued their own currency. The creation of national banks in 1863 was primarily a means to finance the Civil War, but it also represented another layer of financial leverage for the American economy. National banks were a new source of liquidity in addition to the existing system of state-chartered banks, which largely issued paper money backed by gold or silver. National banks and the new paper money known as “greenbacks,” which were not backed by metal, greatly enlarged the US financial system and financed the Civil War, then helped fuel a remarkable period of economic growth in America.

The modern notion of “bad banks” stems partly from the Gilded Age, when large banks and industrial interests amassed monopoly control over whole industries. Businessmen such as J.P. Morgan, John Rockefeller, and Cornelius Vanderbilt consolidated smaller businesses into vast “money trusts” that exercised horizontal and vertical control over much of the US economy and also exerted enormous influence over the American political system. In the muck-raking press of that time, JP Morgan was portrayed as a giant octopus controlling the numerous industries via the tentacles of the money trusts. President Woodrow Wilson said in 1916:

“Our system of credit is privately concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled and dominated governments in the civilized world. No longer a government by free opinion, no longer a government by conviction and the vote of the majority, but a government by the opinion and duress of a small group of dominant men."

Modern day regulation of financial markets (and everything else) has its roots in the progressive reaction to the political and economic power of the Robber Barons of the Gilded Age. In the late 1800s, elected state court judges and other officials were bought and sold like chattel, causing progressives to complain that seeking social justice through the courts was impossible. The Progressive movement of the late 1800s featured appeals for easy money and free coinage of silver, but there was also strong Calvinist strain that also wanted to use the power of government to stamp out sin. The modern-day reliance upon regulators and economists to guide American economic life stems from the Protestant ideal of seeking earthly perfection by placing limits upon individual freedom.

By the time that President Theodore Roosevelt took the oath of office in 1901, the power of the largest banks and corporations had grown to such a degree that it became a national concern for all of the major political parties. Hixon (2005) notes that “by 1914 bankers had virtually complete control of the money-creation process” and JPMorgan was the de facto central bank, an island of liquidity that stood separate from the private clearinghouses of the era. Other banks seeking to transact business with the House of Morgan had to stand in line in the lobby along with the retail customers.

Over the next hundred years, the nature of banks and their relationship to the government agencies that charter and enable their activities, changed dramatically. One of the major transformations in public policy during that era was the adoption of the Progressive agenda, specifically a willingness to use government regulation as a means of controlling the power of the great monopolies and the men who controlled them. Glasser and Schleifer (2001) note that “During the Progressive Era at the beginning of the 20th century, the United States replaced litigation with regulation as the principle mechanism of social control of business.”

In 1902 President Theodore Roosevelt said of regulating the money trusts:

“Good, not harm, normally comes from the upbuilding of such wealth. Probably the greatest harm done by vast wealth is the harm that we of moderate means do ourselves when we let the vices of envy and hatred enter deep into our own natures. But there is other harm; and it is evident that we should try to do away with that. The great corporations which we have grown to speak of rather loosely as trusts are the creatures of the State, and the State not only has the right to control them, but it is in duty bound to control them wherever the need of such control is shown.”

Woodrow Wilson defeated Roosevelt in 1912 and delivered on his promise to rein in the money trusts even as he expanded the scope of the federal government. The creation of the Federal Reserve System in 1913, conveniently enough on the eve of the First World War, began the process of turning over control of the US banking markets to government agencies. Wilson enacted tariff reform, passed anti-trust laws and saw the final passage of the 16th Amendment creating a permanent income tax. The evolution of the US from a Constitutional Republic to a corporate state dominated by the federal government and large corporations would accelerate through WWI and the subsequent financial crises and wars of the 20th Century.

Through the post-WWI inflation of the early 1920s, the US banking system supported the growing wave of financial speculation in stocks and real estate that would eventually lead to financial busts early in the decade and finally to the Great Crash of 1929. Whereas the US economy healed itself in the Depression of 1920-21, by the 1929 market bust President Herbert Hoover set in motion “an unprecedented program of federal activism to head off the business downturn,” notes author James Grant. The economist John Maynard Keynes led the chorus of approval for government intervention, declaring that we shall finally be “free, at last, to discard” the pursuit of self-interest.

Part of the reason that President Herbert Hoover was able to embark upon the vast social engineering experiment known as the “New Deal” was that the behavior of the largest banks was so absurd. Even as real estate prices collapsed in states such as Florida and the markets were roiled by panic selling, the heads of the major banks cautioned calm. Thomas Lamont of JP Morgan, Charles E. Mitchell of The National City Bank and the heads of the other major banks boldly lent millions to support stocks. On the eve of the crash, Mitchell declared that the trouble in the US securities markets was “purely technical” and that “fundamentals remain unipaired.”

But Senator Carter Glass of Virginia, who served as Treasury Secretary during WWI, blamed the market problems squarely on Mitchell, head of the one of the largest banks in the country. By October of that year the US financial system collapsed under the weight of bad investments and fraud. Four years later, as President Franklin Delano Roosevelt took office in March of 1933, every bank from Detroit to New York was closed and had been for weeks. This national catastrophe inspired his memorable phrase about “having nothing to fear but fear itself.”

Out of the rubble of the Great Depression and then WWII came a banking system that was heavily regulated and organized around a system of government agencies designed to ensure the stability of banks and even markets. The Glass-Steagall banking laws crafted by Senator Glass in the dark days of 1933 to separate banking from commerce were accompanied by broad regulation of the securities and housing markets. In the 1930s, the Federal Deposit Insurance Corp under Leo Crowley and the Reconstruction Finance Corp under Jesse Jones literally restructured the US banking system as well as other sectors of the economy. The dominance of the large banks was replaced by the supremacy of the federal government, which assumed a central role in the money markets that was reinforced by the mobilization for WWII.

From VE Day in 1947 through to the end of the 1970s, the US economy was dominated by the partnership between the US government, including various government-sponsored enterprises (GSEs), and the large corporations and large banks which had helped Washington win WWII and later the Cold War. Only in the 1980s did private, non-bank finance separate and apart from the banking system enjoy a brief renaissance in the US, driving the growth of the 1990s and then ending abruptly with the financial crises of that decade.

In the late 1990s, regulators reacted to crises in the securities and money market sectors and inadvertently created the present-day large bank/GSE monopoly. The regulatory changes put in place after the collapse of Kidder Peabody (1994) and the failure of Long Term Capital Management four years later curtailed the ability of nonbank companies to finance themselves and thereby handed a monopoly on short-term finance to the largest banks. Non-bank finance was truncated in 1998 when the Securities and Exchange Commission amended Rule 2a-7, which effectively precluded nonbanks from funding themselves outside the banking system via sales of assets to money market funds.

Since 1998, the largest banks have enjoyed effective control over short-term funding sources for nonbanks operating in the mortgage and other sectors, while the GSEs dominate the long-term debt markets. This terrible error in public policy led directly to the subprime mortgage market bubble and financial collapse a decade later. Today even supposed “innovations” such as peer-to-peer lending are constrained by the large bank monopoly on short term finance. Smaller banks and nonbank mortgage lenders likewise cannot compete with the large banks and GSEs in the long end of the bond market.

The reaction to the 2008 financial crisis only served to confirm the European-style, corporate model of political economy in America, where “big” is considered good when it comes to private enterprises and anything with a government guarantee is even better. No private corporation can compete with a GSE, after all, and today large banks are now fully GSEs. At the apex of the post-WWII credit pyramid and regulatory hierarchy is government debt, followed by securities issued by the various GSEs and then private obligations, in that qualitative ranking. And as in the case of Europe, in America the rights of private investors now are clearly subordinate to the shifting goals of public policy in Washington.


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