From “Boring” Banking to “Roaring” Banking, Part 1

How the Financial Sector Grew Out of Control, and How We Can Change It

Gerald Epstein

Gerald Epstein is a professor of economics and a founding co-director of the Political Economy Research Institute (PERI) at the University of Massachusetts-Amherst. In April, he sat down with Dollars & Sense co-editor Alejandro Reuss to discuss major themes in his current research. This first part (in a three part series) focuses on the dramatic growth in the financial sector and the transformation from regulated “boring” banking to deregulated “roaring” banking.

Dollars & Sense: What should we be looking at as indicators that the financial sector has grown much larger in this most recent era, compared to what it used to be?

Gerald Epstein: There are a number of different indicators and dimensions to this. The size of the financial sector itself is one dimension. If you look at the profit share of banks and other financial institutions, you’ll see that in the early post-war period, up until the early 1980s, they took down about 15% of all corporate profits in the United States. Just before the crisis, in 2006, they took down 40% of all profits, which is pretty astonishing.

Another measure of size is total financial assets as a percentage of gross domestic product. If you look at the postwar period, it’s pretty constant from 1945 to 1981, with the ratio of financial assets to the size of the economy—of GDP—at about 4 to 1. But starting in 1981, it started climbing. By 2007, total financial assets were ten times the size of GDP. If you look at almost any metric about the overall size of the financial sector—credit-to-GDP ratios, debt-to-GDP ratios, etc.—you see this massive increase starting around 1981, going up to a peak just before the financial crisis, in 2006.

Two more, related, dimensions are the sizes of the biggest financial firms and the concentration of the industry. For example, the share of total securities-industry assets held by the top five investment banks was 65% in 2007. The share of the total deposits held by the top seven commercial banks went from roughly 20% in the early postwar period to over 50%. If you look at derivatives trading, you find that the top five investment banks control about 97% of that. So there’s a massive concentration in the financial system, and that hasn’t declined—in some ways, it’s gotten worse—since the financial crisis.

D&S: Could you describe the qualitative changes in financial institution behavior in this same era, and the origins of these changes? When we hear that year 1981, we immediately think of deregulation. Is it just deregulation, or is there more to it than that?

GE: We can roughly think about two periods of banking and finance in the post-World War II era. Coming out of the Great Depression, when there was a lot of financial regulation, the Glass-Steagall Act separated investment from commercial banking, there were rules governing the issuing of complex and risky securities, rules for different kinds of financial institutions in terms of what kinds of assets they could hold. Savings and loans could mostly focus on housing, commercial banks primarily on business loans, investment banks couldn’t take deposits and mostly engaged in underwriting and those kinds of activities. There were interest-rate ceilings, high capital requirements, leverage requirements. During this period, most of the activity of banks, commercial banks particularly, was in terms of taking in deposits and making individual loans—business loans, mortgages, real-estate loans. Many people call this the age of “boring banking.” It was also called the age of “3-6-3” banking—bankers paid 3% interest, lent out at 6%, and got to the golf course by 3:00 in the afternoon.

Then starting in the late 1970s and early 1980s, their activities really changed, partly as a result of financial deregulation, partly as a result of increased competition from other kinds of financial institutions. Relatively unregulated banks could pay depositors higher interest rates, could charge higher interest rates on their loans, and could engage in new kinds of financial innovation—such as securitization, which is placing a bunch of loans into a bundle, such as an asset-backed security or mortgage-backed security, and selling these things off. “Boring banking” could no longer compete, so instead of engaging in one-to-one lending, they started engaging in more activities with the capital markets—bundling up or securitizing loans, selling them off, using derivatives to hedge risks but also to make bets. They kind of became like hedge funds in the sense of doing a lot of trading, buying and selling a lot of derivatives, engaging with the securities and capital markets. But they still had the government guarantees like they were banks.

D&S: You talk about banks that had been comfortably and profitably engaging in highly regulated “boring” activities coming under competitive pressure. How much of this coming from new players and how much is it the banks themselves finding those niches to evade the regulations that existed at the time?

GE: It’s both, for sure. I can’t really tell you about the relative weights of those two factors, but certainly both are going on. So for example, one of the key restrictions that commercial banks were working under was this “Regulation Q ceiling.” There were limits on what they could pay for deposits. In the late 1960s and 1970s, when inflation began taking off, savers were finding that the real interest rates they were getting from their deposits with banks were turning negative, banks couldn’t raise the interest rates they paid to keep depositors. And these aren’t small savers. We’re talking about big corporations and wealthy people. Financial institutions were able to find niches outside the regulations, particularly money market mutual funds and other innovations. Fidelity Investments, for example, was able to create a checking account based on a money market mutual fund. They could start offering much higher interest rates.

But the banks themselves also found out ways of breaking out of this, primarily through the Eurodollar market that developed in the mid-1960s. Citibank, Bank of America, and all these other banks were able to develop these same kinds of financial products overseas, where they weren’t subject to the same kinds of restrictions. Of course, it wasn’t really overseas, it was just accounting changes on their books. One set of accounts was the Eurodollar market and another set of accounts was domestic, but they were all really in the same place, in New York or wherever. They were able to develop these kinds of new products and able to keep their commercial customers and others by setting up in the Eurodollar market rather than in New York.

Citibank was one of the examples of a bank that started pushing the envelope in various ways, to set up these accounts in the United States. The Federal Reserve essentially looked the other way—gave them an administrative pass—in the late 1970s. This just started opening up a floodgate. So it was a combination of new players coming in and developing these kinds of things and the old players figuring out ways around restrictions, primarily by booking all of this in overseas accounts

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