The View From 1776
Monday, March 10, 2008
Transition in Banking
A brief historical overview of changing banking practices abetted by the Fed’s inflationary expansion of the currency.
The main effect of the Fed’s current moves is to bail out financial institutions, saving them from imprudent banking practices. That’s what opponents of creating the Fed feared in 1913.
The Fed’s acting as lender of last resort to tide banks over periodic panics was, in 1913, vastly different from today. Banks then were more prudent, confining their lending to short-term self-liquidating advances, usually with maturities no longer than 90 days. Moreover, borrowers were expected to clean up their credit lines, that is, to pay loan balances down to zero at least once a year to demonstrate the strength of their balance sheets.
In the late teens and early 1920s, the only collateral eligible for rediscount at the Fed was bankers acceptances (export-import financing with maturities again of maximum 6 months) and commercial notes representing domestic shipments of goods to creditworthy companies. Not even Treasury Bills were eligible for rediscount in the Fed’s early days. The effect was to confine commercial banks to financing agriculture and commerce. This tended to limit bank credit expansion to the underlying real growth of business.
Today, as the newspapers tell us in profusion, lenders are heavily involved in originating obligations with maturities up to 25 years.
When inflation began to take off around 1969, banks began to talk about “liability management.” Old line relationship bankers had been schooled to know each corporate client intimately and to stick with that client through the ups and downs of the economy. After 1969 the game shifted to finding new sources of bank funds to carry new types of lending. Banks became something analogous to traffic directors for funds coursing around the world via 24/7 satellite networks.
Two major developments triggered this transition.
First, around 1960 treasurers of major corporations became conscious of the value of their dormant bank balances. For generations banks had required maintenance of compensating deposit balances equal to 15% of a borrower’s line of credit. Corporate treasurers began to refuse to leave those large idle balances with the banks, demanding instead that the banks name a fee to be paid for extension of credit lines. Great money center banks like City Bank and Chase, relying heavily on corporate business and with little individual consumer banking balances, were squeezed as they lost bank balances on the liability side of their balance sheets needed to support the loans on the asset side.
Second, the initial answer to the problem was creation in 1961 of the negotiable certificate of deposit, the brain child of Walter Wriston, then head of City Bank’s foreign department, later chairman of the bank. Corporations could invest their surplus cash balances in those bank-issued negotiable CDs, at money market interest rates, then hold them or sell them in the money market to other domestic or foreign short-term investors.
Thus began banks’ focus upon the liability side of their balance sheets. The aim was to find new sources of funds to support their loans. At the same time pressure mounted for changing the regulations to make other categories of assets eligible for rediscount at the Fed.
Continuation of this transition led the banks to structure loans in standard formats that would enable them to sell them into the secondary market. Today, banks are driven by fees earned from originating loans, as in exotic structured investment vehicles.
This has led the banks to take on deposit and contingent liability for SIVs in totals vastly greater than they ever could redeem with their own liquid assets.
None of this could have occurred without the Fed’s continuing to pump inflationary amounts of money into the system and without the Fed’s readiness to bail the banks out as with today’s Term Auction Facilities (TAFs) that allow banks to borrow at interest rates lower than those normally available at the Fed’s discount window.