Banking deregulation has become a highly controversial and charged issue. On the one hand, it has been accused of precipitating the sharp increase in bank and thrift institution failures in the last few years–including the failure of Chicago`s First Federal Savings (now Citicorp Savings) and Talman- Home Federal Savings, both in 1982, and Continental Illinois National Bank and Trust Co. of Chicago, in 1984. It also has been blamed for excessive increases in bank service charges on small deposit accounts, higher home mortgage rates (by granting thrifts nonmortgage lending powers) and unfair competition for local banks from giant out-of-state banks and nonbank ”unregulated” firms.
On the other hand, deregulation has been credited with providing smaller depositors with market or closer-to-market interest rates on savings through phasing out rate ceilings on bank deposits and authorizing money market and NOW accounts; allowing commercial banks and thrifts to survive by permitting them to compete better with money market funds; and increasing competiton for consumer and small business loans by opening these areas to thrift institutions.
Whatever the final verdict on bank deregulation, it is true that everyone operates under a new system nowadays–bankers, nonbankers, business firms and consumers. Some will benefit from the new system and some will be harmed. Most of us operate more comfortably, if not better, in an environment of stability and certainty. Changes in the ground rules, particularly those as large and abrupt as banking deregulation, produce uncertainty and are difficult to adjust to.
By permitting the forces of competition greater sway, deregulation should have the net effect of making life more difficult for both banker and consumer but also providing higher rates of profit for successful bankers and lower costs for successful consumers. In short, the advantages of deregulation are likely to outweigh the disadvantages.
But why were regulations imposed in the first place, and why have they been removed?
Commercial banks have tended to be regulated more than most firms in all countries, primarily out of fear of excessive concentration of economic power and of the effects of bank failures on lower-income groups, who hold proportionately more of their wealth in bank deposits. Bank failures are dreaded, too, because they ignite can downturns in overall economic activity. In the U.S., the fear of concentration led to early restrictions against any branch banking at all in some states (Illinois even banned banking altogether briefly) and interstate branching in all states. Bank participation in nonbanking activities also was restricted.
As an aftermath of the Great Depression, during which 10,000 banks failed between 1929 and 1933, additional restrictions were imposed on starting new banks, on interest rates banks were to pay on deposits (Regulation Q) and on bank participation in securities underwriting and trading. Federal deposit insurance was also introduced.
These restrictions erected regulatory walls that attempted to separate
(1) commercial banks from banks in other geographical market areas and most other financial and nonfinancial firms, and (2) some bank products, such as demand deposits, from other bank products, such as time deposits. These walls protected banks from potential nonbank competitors but also prevented banks from competing in profitable nonbank areas.
The system appeared to work well for some 40 years until the mid-1970s. But much of the success of the regulations was in appearance only. For much of this period, the constraints did not bite, and when they did they were slowly liberalized. But starting in the mid-1970s, the regulatory walls were hammered by two forces that could not be stopped by minor, patchwork repairs. The sharp rise in interest rates fueled by the acceleration in the rate of price inflation provided the incentive for all participants in the financial markets to intensify their search for the highest return (or lowest cost). At the same time, major advances in telecommunications and computer technology provided the means by which funds could be transferred quickly and cheaply around interest rate barriers. The upshot was that other firms began to invade the profitable turf of commercial banks and thrifts, and commercial banks found ways to add services, such as discount security brokerage and money management.
The combination of high interest rates and technological advances in telecommunications did not just punch a few holes in the regulatory walls or permit funds to fly just a few inches over them. It effectively tore many of the walls down and made raising the others impractical. Not all the government`s regulators could put the old walls together again, even if they wanted to.
No longer will the government dictate the product line, product prices and geographical market area to bankers and protect them from intense competition. From now on, it is up to individual bankers to choose their product lines, prices and market areas. If they do so correctly, the payoff is bigger than before. If they do so incorrectly, the penalty is greater than before–failure.
The increase in bank failures in recent years is partially the result of deregulation. As in any competitive industry, well-managed or just lucky firms drive the poorly managed or unlucky firms out of business. Bank management needs to be sharper than before to survive. Likewise for the consumer. The first bank may not be the best buy. Some consumers will stumble in the search or just give up and not make the wisest purchase.
Will such a system be successful? Both economic theory and practice would suggest so. Historical evidence is clear that competitive markets produce the largest quantity at the lowest price. Thus, the average consumer will be better off. But how about increased bank failures? Can a few failures start a chain reaction that increasingly topples other banks in a domino process and possibly the economy, as in the 1930s? This is highly unlikely.
Federal deposit insurance, one of the reforms introduced in the 1930s, effectively adds a federal government guaranty on the par value of bank deposits up to a minimum amount. The current minimum is $100,000; by statute the current maximum is arbitrary and left up to the Federal Deposit Insurance Corp. In the case of Continental and most failed banks, the FDIC has guaranteed the full amount of all deposits.
Regardless of the amount, however, deposit insurance has stopped the conversion of small bank deposits into currency. In the past, this type of bank run drained reserves from the banking system as a whole, and forced a multiple contraction in bank loans and deposits that was capable of igniting a chain reaction that could topple other banks. In contrast, large depositors run on a bank in which they lose faith by transferring their funds to other banks or to safer Treasury securities. In the later instance, the seller of the security receives the deposit. In either case, funds do not leave the banking system as a whole and a domino effect is not started.
Although there were runs on Continental Bank by large depositors, small depositors did not line up to withdraw currency as in pre-FDIC times. Nor were such currency lines visible in the earlier First Federal and Talman-Home failures. Thus, in contrast to earlier days, a small number of bank failures can be confined and are unlikely to be more detrimental than the failure of other large and important firms such as International Harvester, Charter or Baldwin-United. In the small probability of stronger repercussions, the Federal Reserve can provide sufficient liquidity to banks in its role of lender of last resort. To maintain efficiency, however, the market must be permitted to punish as well as to reward.
This is not to argue that no regulations whatsoever are required in banking. The longstanding fear of excessive concentration of economic power remains to be addressed. But the regulations designed in an earlier era to wall off banking and make life easier and less uncertain for both banker and consumer cannot be put back together again in this era. Although everyone will not benefit, after the initial churning and shakedown, the benefits to bankers and consumers overall should outweigh the costs.
