Saturday, February 7, 2009

Why Rescue Banks?

What is it that a bank really does? In college, many decades ago, I was taught that banks served to bundle many small investments to make them available for investors to create productive businesses. More recently, the idea became popular that banks specialized in accumulating information that made them ideally suited to determine which investment projects would be viable and which would lack merit. Of course, with the demise of Glass-Steagall, banks did accumulate massive amounts of information -- especially when the same company ran a person's bank, stockbroker, insurance company, and credit card. But that kind of information is something entirely different.


By the time this new idea of banks as information specialists became widely accepted, the business of lending to large corporations was shrinking. Large corporations were able to finance themselves by borrowing directly in the commercial paper market. To compensate for this lost business, banks began to see their future in collecting -- organizing mergers and acquisitions, bundling financial investments in novel ways, and, on the retail side, late fees from unwary customers. And yes, bundling subprime loans. Is any public purpose served by slicing and dicing financial paper?

We all know that until recently they were very successful, but the question is whether their success reflected any public purpose. We now know that the financial system was not particularly efficient in gathering information. If it was, TARP would not exist.

Why couldn't banks be more like a public utility, as they were supposed to be in the age of Glass-Steagall? Just as a public utility sends water or electricity to where it is needed, public banks could run checking accounts for the public, paying bills and accepting deposits.

9 comments:

Shag from Brookline said...

You might be interested in Prof. Melvin Urofsky's OpEd in today's NYTimes that references Louis Brandeis' "Other People's Money" on the subject of banks. A friend loaned me the book but I haven't had time to read it as yet. Urofsky's column should serve as a remineder to Pres. Obama's economic team.

Michael Perelman said...

Thank you. Brandeis also played a useful role in promoting regulation of railroads.

TheTrucker said...

There are a lot of people who do understand basic conceptual banking and many more who do not understand the current financial mess. I am very, very fond of KhanAcademy's Utube series on "Money and Banking", and even more pleased with the series on the "Credit Crises". Coming directly to the point is video #14 in the "Credit Crises" series.

I think that the "age of Glass-Steagal" was supposed to maintain a firewall between "commercial banks" (these are the banks that take deposits and create more deposits through the loan process), and the "investment banks" which were actually not to be part of the FDIC coverage and which were not deposit institutions and could not create money via the loan process. They were in the "derivative" world and the commercial banks were in the 10 to 1 fractional reserve world. The Commercial banks and the S&L's were the people that did the mortgages and autos and the large durable goods loans and the investment banks were the people that did the shopping centers and the loans to Mexico. If you wanted to buy a house you had to have at least 10% for a down payment and you still had to do PMI (mortgage insurance) until such time as you had 20% equity in the home. The "Down payment" thing was for cars too.

Shag from Brookline said...

Greg Mankiw's column in today's (2/8/09) NYTimes includes his statement that Glass-Steagall extended the Great Depression. Do responsible economists share this opinion?

Michael Perelman said...

He wrote about Smoot-Hawley, not Glass-Steagall.

rosserjb@jmu.edu said...

michael,

So, are you proposing that we nationalize the banks for real? Or perhaps we should set up "public utility" banks that people can deposit money in that do little or nothing else? This is sort of what they have in much of Europe and also Japan, with postal savings banks (where post offices are still owned by the government).

The largest bank in the world is the Japanese postal savings bank, and there has been a huge battle there over privatizing it, which has been proposed by several successive LDP governments, although I think that somehow it has never quite gotten through fully or been fully executed. Last time I was in Japan a few years ago, one parliamentarian committed suicide because he had voted against his faction leader on the issue.

Shag from Brookline said...

Thanks for correcting my error on Mankiw's column. I can agree with him on this column. I think my error arose from the number of articles appearing recently with revisionist attacks upon the New Deal as a means of denigrating Pres. Obama's economic proposals. I have been unsuccessful in locating the article that had challenged Glass-Steagall as prolonging the Great Depression.

Howard Covitz said...

Rosserjb,
It is my understanding that postal savings banks were once a major component of the U.S. landscape as well, back in the day.

Michael Perelman said...

Yes, but not that major since they were intended for the less affluent.