Thursday, July 23, 2009

Economic Forces Pushing Banks

My post (reprinted below) on Rortybomb about his call for "repealing a fair amount of the banking deregulation."
The 1980's changes to the banking system are the results of the 1970s inflationary economic environment. Fed Res Reg Q capped interest rates on deposits at banks well below the inflation rate and banks gave toasters to attempt to attract deposits. Consumers removed banking deposits and put them into money market mutual funds, which paid a higher rate than banks. Banks lost their cheap, stable funding source. The Fed modified Req Q to allow market rates on deposits. Banks then had higher funding costs, which pushed them into higher rate lending, which attracts riskier borrowers. It also made alternatives to deposits less comparatively expensive. Additionally, the higher costs pushed banks to a more efficient use of funds through loan participations and securitizations. With more price sensitive deposits, depositors sought better rates and they became less geographically restricted. With a more volatile, less stable, less inertial deposit base, there came the need for geographical diversification of banking deposit gathering. Banks merged and expanded across the US.

By the 1980s, large US companies had easy access to the capital markets for equity and debt. They had very little need to borrow from banks. Banks targeted middle market companies, but the public debt and equity markets opened to these companies also. Banks lost commercial lending market share. Banks pushed into credit cards, leverage buyout financings and increased their share of commercial and residential real estate lending to develop interest income and fees to pay the banks' higher deposit gathering interest rates and expenses. Banks tried to eliminate branches to cut costs, but found deposit gathering needed a branch system.

Financial innovation, whatever that undefined concept means, is a continuation by banks to use their resources efficiently to generate income to offset their needs to offset their higher expenses of operation in a modern environment. Modern financial innovation is about lowering the costs of raising funds, investing, and lending.

As soon as short-term rates rise again, banks will find deposit gathering difficult unless their rates are competitive to alternatives. Any repeal of rules to a previous form of bank operations, such as caps on credit card fees and interest rates, limits on securitizations, limits on types of lending, increasing capital, etc., will lower a bank's potential revenue. Less income will force banks to lower their expenses, including lowering interest rates paid on deposits and merging into larger institutions to achieve economies of scale. As soon as market interest rates rise, banks will again face disintermediation as they did in the late 1970s and early 1980s. Banks will face either a funding crisis or stop lending at a time when the economy is rebounding and there is demand for commercial and consumer lending. Either will force Congress to undo its restrictions.

The economic forces pushing banks into higher risk lending and efficient use of capital will not disappear because Congress is upset about the current banking crisis. Imposing restrictions on banks, such as increasing capital and restricting activities, fees and interest rates, is an implied recognition that banking is passé. It will force alternatives to our current banking system, such as private equity, to develop and mature much faster. Whether that is good or bad, better or worse than what we currently have, will unfold over the next decade or two. However, the underlying economic forces affecting banking will not abate because some of the outcomes trouble some people.

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