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Monday, May 4, 2009

The Strange History of Non-Bank Banks -- and its Link to the Origins of the Current Economic Crisis

Researching the origins of the current economic crisis makes me feel old. I’m used to thinking of the Reagan administration as a fairly recent era. But here I am reviewing policies that were put in place at the time I came of age, and I realize that what I’m doing is basically historical research.

Looking back from here in the late 2000s at the administration that was in power in the 1980s is not too different from someone in the 1960s researching the Roosevelt administration. And that thought makes me feel old.

The topic du jour that sent me once again back to the 1980s is the concept of the “non-bank bank,” to which a Reuters UK article indirectly alludes in an analysis of comments President Obama made on Saturday in an interview for the New York Times magazine.

Discussing the Obama administration’s outline of expanded financial regulatory powers to prevent a future crisis of the sort that the U.S. is now currently confronting, the Reuters article says that part of the proposed strategy is to create a regulatory body “with the authority to seize large non-bank financial firms, such as insurers, hedge funds, or private equity companies, if they are deemed to threaten the stability of the financial system.”

This made me recall the concept of the “non-bank bank.” It’s a term that I suspect most of us, like me, haven’t heard in some time -- which is probably an indication of just how much of a taken-for-granted fixture this kind of institution has become since its origin in the 1980s.

Although I don’t precisely remember what year it was that I first heard the term, I do have a fairly vivid recollection of the incident. I was in the kitchen at my parents’ house, where I was still living as a commuting college student. My dad and I were going through the evening ritual of dinner among the avocado appliances, accompanied by a news broadcast from a local AM radio station on the NuTone radio/intercom console built into the wall of the eat-in kitchen.

The kitchen, wallpapered in an early-American country pattern of reddish-orange flowers, would have served as a perfect model for the set designer for That 70s Show. Mom, due to a bad back that made it uncomfortable to sit on the hard kitchen chairs, usually didn’t join us at the dinner table. She was enjoying her repast in the living room which, with its rust-colored carpet, could also have served as an exhibit of 1970s decor.

One of the stories on the news broadcast Dad and I were listening to as we dined was about non-bank banks. I don’t recall what specifically was being reported about them, but perhaps it was September 1984 when, according to an article in the January 23, 1986 edition of the New York Times, a Federal appellate court ruled that the Federal Reserve Board did not have the power, without new legislation, to broaden its definition of a bank in order to exercise regulatory authority over an emerging category of financial institution sometimes referred to as a non-bank bank.

“What in the world is a non-bank bank,” Dad wondered out loud after hearing the news story. It was a rhetorical question, of course, because neither one of us knew the answer. It was the 80s, after all, so a quick hop on to Google to find out wasn’t an option. But we did have a vague awareness that certain types of financial organizations, such as insurance companies and investment firms, were trying to get into services traditionally provided by banks. Little did we know that this news story was just one indicator within a much bigger picture of a vast wave of change in the financial landscape that, about 25 years later, would have such profound consequences for the U.S. and world economy.

The Fed appealed the non-bank banks case all the way to the U.S. Supreme court, but lost in an 8 to 0 decision on January 23, 1986. That decision was the main subject of the New York Times article referenced above. Prophetically, the article went on to say that the Court’s ruling was “likely to speed the movement toward interstate banking and the expansion of insurance, retail, securities and other companies into financial services traditionally performed by banks” and quoted Federal Reserve Board Member Charles Partee, in what reads like a warning of dire consequences to come, that “Every merchandiser in the country will have a bank” [with “have a bank” presumably meaning “operate its own bank”].

Now, do you remember who was Chairman of the Fed in 1986, when the Supreme Court made this decision? It was none other than Paul Volcker, who now happens to be one of President Obama’s top economic advisors. So in 1986, under Volcker’s leadership, the Fed appears to have been fighting what it found to be alarming efforts to expand, outside of its regulatory authority, financial activities traditionally associated with banks.

But the story gets even more interesting, because the New York Times article goes on to say that “the Reagan administration, which favors more competition and less regulation,” joined the large companies that wanted to offer financial services competing with those of traditional banks in “urging the court to invalidate the Fed’s regulation.”

So we see the Fed, under the leadership of Volcker, an appointee of President Carter, at odds with the Reagan administration, advocating for a more cautious and controlled approach to the development and growth of the financial services industry.

But the Fed did not prevail. And the rest, as we now know, is history. Interstate banking and the entry of other financial services institutions into traditional banking functions indeed expanded rapidly, paving the way for the folks who brought us such brilliant innovations as the credit default swap.

Local and community banks all but disappeared. In my home town, for example, Suburban Trust Company became Suburban Bank and then Sovran Bank, which before long was absorbed by NationsBank, which was in turn absorbed by Bank of America. My first credit card from an unsolicited, pre-approved offer -- with a whopping $5,000 line extended to me as a student in the 1980s taking home about $50 weekly from a weekend-only job -- was from an out-of-state bank I’d never heard of that ultimately became part of Chase.

In 1987 Volcker departed the Fed, not long after it lost the non-bank banks case. His successor, Allan Greenspan, was once a disciple and part of the inner circle of Ayn Rand. Rand espoused views that are perhaps among the most extreme in history on the supposed virtues of markets free of government regulation. On the subject of regulation, she believed that all that was necessary was the self-regulation of heroic captains of industry who, based solely on the motivation to protect their profitability and reputations, would never do anything lacking in integrity. In the context of the current crisis, those views look astonishingly naïve, given the reckless lack of self-regulation we have witnessed from certain key players.

There’s a certain poetic justice in the fact that Volcker is finally getting a chance to help clean up the same mess that the Fed under his leadership apparently tried to stop, during its earliest stages, in the 1980s. And it even helps put into perspective the issue I opened with of “feeling old” when I dig into the origins of the current crisis. While I was in college and still living with my parents during the non-bank bank controversy, Volcker was already old enough to be the Fed chairman. So imagine how old he must feel now.

I’m also amazed at how consistently, so far, the eye seems to fall squarely into the 1980s when one looks for the origins of the current crisis. It seems that we are truly witnessing the end and final outcome of an era that began when President Reagan, in one of the earliest and most famous speeches of his administration, proclaimed a freeze on new regulations and pledged to get rid of as many as possible. And so he did, including what appears, in effect, to have been a systematic dismantling of certain safety measures that were put in place after the Great Depression to prevent a recurrence -- to which as a consequence, we seem to have come alarmingly close. Sphere: Related Content

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